The Cash and Carry model is also known as non-arbitrage model. This model assumes that in an efficient market, arbitrage opportunities cannot exist. In other words, the moment there is an opportunity to make money in the market due to mispricing in the asset price and its replicas, arbitrageurs will start trading to profit from these mispricing and thereby eliminating these opportunities. This trading continues until the prices are aligned across the products/ markets for replicating assets.

Let us understand the entire concept with the help of an example. Practically, forward/ futures position in a stock can be created in following manners:

· Enter into a forward/futures contract, or

· Create a synthetic forward/futures position by buying in the cash market and carrying the asset to future date.

Price of acquiring the asset as on future date in both the cases should be same i.e. cost of synthetic forward/ futures contract (spot price + cost of carrying the asset from today to the future date) should be equivalent to the price of present forward/ futures contract. If prices are not same then it will trigger arbitrage and will continue until prices in both the markets are aligned.

The cost of creating a synthetic futures position is a fair price of futures contract. Fair price of futures contract is nothing but addition of spot price of underlying asset and cost of carrying the asset from today until delivery. Cost of carrying a financial asset from today to the future date would entail different costs like transaction cost, custodial charges, financing cost etc whereas for commodities, it would also include costs like warehousing cost, insurance cost etc.

Let us take an example from Bullion Market. The spot price of gold is Rs 15000 per 10 grams. The cost of financing, storage and insurance for carrying the gold for three months is Rs. 100 per 10 gram. Now you purchase 10 gram of gold from the market at Rs 15000 and hold it for three months. We may now say that the value of the gold after 3 months would be Rs 15100 per 10 gram.

Assume the 3-month futures contract on gold is trading at Rs 15150 per 10 gram. What should one do? Apparently, one should attempt to exploit the arbitrage opportunity present in the gold market by buying gold in the cash market and sell 3-month gold futures simultaneously. We borrow money to take delivery of gold in cash market today, hold it for 3 months and deliver it in the futures market on the expiry of our futures contract. Amount received on honouring the futures contract would be used to repay the financer of our gold purchase. The net result will be a profit of Rs 50 without taking any risk. (In the entire process, we have not considered any transaction cost-brokerage etc.)

Because of this mispricing, as more and more people come to the cash market to buy gold and sell in futures market, spot gold price will go up and gold futures price will come down. This arbitrage opportunity continues until the prices between cash and futures markets are aligned.

Therefore, if futures price is more than the future fair price of asset/ synthetic futures price, it will trigger cash and carry arbitrage, which will continue until the prices in both the markets are aligned.

Similarly, if futures prices is less than the future fair price of asset/ synthetic futures price, it will trigger reverse cash and carry arbitrage i.e. market participants start buying gold in futures markets and sell gold in cash market. Now people will borrow gold and deliver it to honour the contract in the cash market and earn interest on the cash market sales proceeds. After three months, they give gold back to the lender on receipt of the same in futures market. This reverse arbitrage will result in reduction of gold’s spot price and increase of its futures price, until these prices are aligned to leave no money on the table.