Let’s have a closer look at this by taking an example of Equity stocks:
On 31 December, price of XYZ limited is INR 1,000/- in the cash markets (Spot market) on the stock exchange.
Futures price of the same stock for March 2018 delivery is INR 1,030/-
We have the following information with us:
Time to expiry: 3 months
Borrowing rate prevailing: 10%
Annual dividend payable on this stock: 25% payable before 31 March
Based on the above information, the futures price for this stock on 31 December should be
= 1000 + (1000*10%/4) – (0.25*10)
= 1000 + 25 – 2.5
= 1022.5
In the above pricing example: as per the ‘cost of carry’ criteria, the futures price is INR 1022.5, which is less than the actual price of 1030/- (the futures price for March contract). Which means that the futures pricing is over-priced. Due to this differential in pricing in the two markets (spot and futures), one can go for arbitrage opportunities.
In other words; (arbitrage Opportunity) – this means one may want to buy in the spot markets and carry it for three months. So one may buy in the spot market and sell in the futures markets and the differential amount is the profit.
When F > (S + CC – CR): sell the overpriced futures contract, buy the underlying asset in spot market and carry it until maturity of the futures contract.
This is referred to as ‘cash-and-carry’ arbitrage
When F < (S + CC – CR): Buy the underpriced futures contract, short-sell the underlying security in the cash (spot) market. One can invest the sales proceeds of the short-sale until the maturity of futures contract.
This is typically called ‘reverse cash-and-carry’ arbitrage.