A Yield Alternative – The Cash and Carry Trade
With rock bottom interest rates on low risk assets like treasuries and bank CD’s, what alternatives do investors have to generate yield?
One alternative is to take on more risk. This risk can be in the form of credit risk, for example by investing in high yield bonds for example. It could take the form of market risk, like investing in high dividend paying stocks. It could even be a combination of risks. For example, investing in real estate trusts. Here your investment can be impacted by interest rates, economic conditions, quality of execution and other factors. These higher volatility strategies serve core functions in an investor portfolio. However, they are not necessarily the right tools for an investor’s allocation to cash and liquid investments.
Enter the cash and carry trade. Cash and carry is a popular pair trade involving buying a physical commodity and also selling futures on the same commodity. It is an arbitrage strategy where the investor aims to capture the positive slope, or contango, in a futures term structure. Cash and carry trades aim to eliminate exposure to the price of the commodity, and generate a yield.
This may sound complex to investors that are unfamiliar with the cash and carry trade. The truth is, it’s really straightforward. Investors can use this yield alternative to generate income without taking on net exposure to commodity prices. For some investors there are even tax advantages compared to holding interest bearing investments.
How does the cash and carry trade work?
A common example of this carry trade works like this:
- In June the investor buys 500 oz physical gold, or warehouse receipts representing the same quantity of gold.
- At the same time, the investor sells short five August COMEX futures (each gold futures contract is for 100 oz).
Assuming the gold market is in contango, the investor is able to sell the August gold contracts at say a $6.00 per oz premium to the price paid for the physical gold. Here the investor has equally sized offsetting positions (long physical gold, short futures). Consequently, the investor doesn’t have net exposure to the gold price. Therefore, the investor is agnostic to whether the gold price rises or falls.
If the investor holds the position until near the futures contract maturity, it is customary for the futures price to converge with the spot price. At this point, having earned the $6/oz premium, the investor can unwind the trade. To do this, the investor sells the physical metal and buys back the short August futures. Alternatively, the investor can continue the carry trade. To do this the investor buys back the short August futures, and sells short the same number of October gold futures. Provided the market remains in contango, the investor will be able to again sell the longer dated futures at a premium to the August futures. In doing this, the investor continues the carry trade and again waits for the futures price to converge with the spot price.
When effective the investor generates a net yield on the cash and carry trade that is equal to the contango earned on the short futures position, less the cost of storing the physical gold, less the cost of trading commissions.
What is contango?
Cash and carry trades work for many commodities, so long as the market is in contango, and the contango is steep enough to also cover the storage and insurance costs of the commodity in question. Some commodities like gold and silver usually have sufficient contango to generate cash and carry yields better than treasuries or bank deposits. Other commodities like coffee have very steep contango. However, these can present storage challenges since coffee spoils over time and can be damaged by humidity or rodents. Some commodities like copper can see their futures curve move between steep contango and backwardation. Therefore, they can present occasional opportunities for outsized carry trade returns.
So, what is contango and why does it exist? Contango simply means that the futures price is higher than the spot market price. Or, that further dated futures are priced higher than shorter dated futures. Why would someone agree to buy a futures contract at a price higher than spot? The answer is often driven by the cost of storing and insuring the commodity in question. For perishable commodities, the cost of spoilage can also be a big factor. Contango also tends to include the opportunity cost of money. If an investor buys a physical commodity and stores it, she needs to pay for the commodity at the time of purchase. If instead the investor buys a futures contract, she puts up margin but does not need to pay for the commodity until she takes delivery. Therefore, she can invest that money and earn interest.
Backwardation is simply the opposite of contango. It means that the futures prices are lower than the spot price. Cash and carry trades do not work in backwardated markets.
Explore cash and carry opportunities in the current market
Investors use commodity cash and carry trades both as a cash substitute and also as a core yield alternative. These carry trades can be used to enhance yields in a portfolio without taking on net exposure to commodity prices. We hope you’ve found this guide a practical and useful tool to help you evaluate cash and carry trades. Please let us know if you have any suggestions on how we can improve it, or any of our resources. If you would find it helpful to talk through your questions and explore the cash and carry trade opportunities in the current market please contact us. We would be grateful for the chance to help.