It occurs by capitalizing the price difference in three instances –
Let’s discuss the three major strategies that occur in the Indian Market.
It’s used when there is a price disparity between futures and spot market of a particular commodity. Consider a commodity trader buys a bag of soybeans from the market at 500 INR. We must assume a holding cost for 6 months lets say, 50 INR.
Holding cost = Storage cost + Risk-Free Rate
Now if the trader manages to short the futures at 600 with an expiration of the contract being 6 months in future, he can deliver the stored commodity and earn a risk-free profit of (600-500-50) = 50.
This is called cash and carry arbitrage.
The trader carries the commodity into the future and cashes out via the futures contract.
Reverse cash and carry are also possible.
It involves simultaneous purchase and sale of futures contracts on the same underlying asset expiring on different dates. Its modelled to profit from the difference in the rate of movement of prices between near term and far term futures contracts.
It involves long on the short-term future contract and short on the far-term future contract.
It is an apt example of Bull Spread.
It involves short on the short-term future contract and long on the far-term future contract.
Advantages of these spreads –
Considering different commodities on the same exchange having the same cash flow or in the same category, there is a possibility of creating an inter-commodity arbitrage. It’s pure speculation. Arbitrager long one contract and short another the other contract to make a profit.
Hindalco moves with the price of Aluminum; it doesn’t fall under this kind of arbitrage but is a notable example of correlation.
Doing a recap, Spotting a deterministic arbitrage opportunity in commodities –