The emergence of the Market for Derivative products, most notably forwards, futures and options can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature the financial markets are marked by a very high degree of volatility. Through the use of derivative products it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices on the profitability and cash flow situation of risk averse investors.
On the futures expiration date, the spot and the futures price converge. Now unwind the position.
- Say the security closes at Rs.975. Buy back the security.
- The futures position expires with a profit of Rs. 10.
- The result is a risk less profit of Rs.25 on the spot position and Rs. 10 on the futures position.
If the returns you get by investing risk less instruments is more than the return from the arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse cash and carry arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost of carry. As we can see, exploiting arbitrage involves trading on the spot market. As more and more players in the market develop the knowledge and skills to do cash and carry and reverse cash and carry, we will see increased volumes and lower spreads in both the cash as well as the derivatives market.