Cash-and-Carry Arbitrage

Cash-and-carry arbitrage is a risk-free profit strategy in derivatives markets that exploits the mispricing of a futures contract relative to its fair value — when the futures price is higher than the theoretical fair price determined by the spot price plus the cost of carry (financing cost minus dividends). The strategy involves: buying the underlying asset (or basket of stocks) in the cash/spot market, simultaneously selling the corresponding futures contract at the inflated price, and holding the position until futures expiry when the futures price converges to the spot price. The profit equals the difference between the inflated futures price and the theoretical fair value. In Indian equity markets, cash-and-carry arbitrage is the fundamental mechanism that arbitrage mutual funds exploit — these funds buy NSE-listed equities in the cash segment and simultaneously sell Nifty or stock futures contracts, earning the futures basis (the premium of futures over spot price) as a near-risk-free return. Because these returns are earned with virtually no market direction risk, arbitrage fund returns closely track short-term money market rates. In India, arbitrage funds are taxed as equity funds (if held over one year, gains are subject to LTCG at 12.5% above ₹1.25 lakh) — making them more tax-efficient than liquid or short-duration debt funds for investors in higher tax brackets seeking liquid, low-risk returns.