No Arb Range, Cash-and-Carry, and Reverse Cash- and-Carry

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FinNinja

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I just want to make sure that my understanding of these concepts are correct:
1. the no arbitrage range for a commodity Fwd is Se^[(r+storage-c)*t] <= FWD <= Se^[(r+storage)*t]
2. If FWd price < Se^[(r+storage-c)*t] then this is an arbitrage opportunity and the FWD should be bought and the spot should be sold short (Called a Reverse Cash-and-Carry)
3. If FWd price > Se^[(r+storage)*t] then is an arbitrage opportunity and the spot should be bought and the FWD should be shorted (called a Cash-and-Carry)
 
I am totally punting cash and carry calculations, they just give me trouble for some reason, i have a mental block and just shut down when i see the words “cash and carry”. It was like the same thing for currency swaps and triangle hedges at LII.
I get the concepts above, just not the step by step calc.
 
I had to really sit down and focus on these all last night to come up with just these three pieces of information. I think this is another reading that is put together poorly. It was very difficult just to understand when to cash and carry and when to reverse cash and carry. If you look at exhibit 7 and 8 in the book they tell you the no arbitrage restriction equation, but that’s for NO arbitrage ability. The exhibits are examples of the transactions to take if there IS an arbitrage opportunity. It is not very clear that you enter into the cash and carry/reverse cash and carry if the equations presented do NOT hold.
I also feel there are too few EOC for this reading. 3 questions for this type of material just does not cut it for me to have a deep understanding of this.
Thanks for the confirmation Janakisri!
 
Standard carry trade involves borrowing cash ( cash , not the commodity ) . What do you do with cash ? You buy commodity at spot ( you can lend it or store it )
To close the borrow of the cash you’d have to Sell the commodity forward so someone pays you cash in the future. And you deliver the cash to whoever gave it to you in the beginning.
( most notably JPY carry trade involved borrowing Japanese Yen , buying Dollars with it and pocketing the interest rate difference because JPY was so stable for a long time and Jap interst rates were close to zero) .
So a reverse carry trade would involve lending cash , right? So you have to get the cash by borrowing the spot and selling it short.
Go from there. To close the lend of cash you’d have to go long commodity forward so when the short side delivers the commodity to you in the future , you can deliver it from whoever you borrowed the spot , getting the money back from whoever you loaned the cash .
If you remember that cash-and-carry involves borrowing cash , you’ll remember the rest.
 
So, if only lease rate is given then this equation would be:
No ARB range for a commodity Fwd : Se^[( r - lamda )*t] <= FWD <= Se^[ r *t]…..is it right?
 
markCFAIL wrote:
I am totally punting cash and carry calculations, they just give me trouble for some reason, i have a mental block and just shut down when i see the words “cash and carry”.
Click to expand...
Exactly, how I get a mental fart when I see C&C or Reverse C&C words.
 
I think the curriculum does a poor jumbled up explanation on the entire commodities section.
 
For what its worth for the guys with a block, I was realyl bad the same way, now Im jsut kind of the same way…major decrease in degree and I did jsutlike Fin Ninja said…I sat down and just di it over and over. I did schweser, eocs, and blue boxes all at one time and now it *kinda* makes sense…
I memorized that if forward is greater than spot its cash and carry and jsut remembered you have to buy spot. So we gotta borrow for that and pay interest.
At the end, you pay storage, receive lease, pay interest on the borrowing and receive forward - spot.
I hope all that above is correct, workign off memory..i ahve to ahve paper in front of me…
Anyhow that was intended to be words of encouragement, just do a bunch of it….it’ll kinda come clear.
 
Cash and carry –> Spend cash today to buy the commodity and carry the asset and sell the forward. Why? You think commodity forward is earning greater than interest rate. What if you don’t have cash? You borrow. If you use your own cash, you loose the interest rate.
Revers Cash and carry –> You think commodity forward is earning less than the interest rate. You sell the commodity, buy the forward and invest in bond. What if you don’t have commodity? You borrow it or lease it or short sell it. If you use your commodity that you own you loose the convenience yield/lease rate.
In either case you are trying to take advantage of an arbitrage oppurtunity, start with a zero and end with a profit.
The matrix that CFA gives is not very intuitive, however the explaination should help.
 
From my understanding, you would do a cash-and-carry if the forward > spot. You buy the spot, sell the forward… my mental model right now is it is like you are trying to make a spread.
And you do “reverse cash-and-carry” if spot > forward. You buy the forward, sell the spot. Again, my mental model is it is like trying to profit from a spread.
Am I basically right on this? It seems to work when I apply the logic like this to all the problems I have done so far. I’m doubtful my mental model is right though.
 
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