Introduction

Arbitrage plays a crucial role in financial markets, enabling traders to capitalize on price discrepancies between related assets. In the realm of commodity forwards, arbitrage strategies can exploit pricing inefficiencies to generate risk-free profits. This chapter delves into the concept of arbitrage in commodity forwards, explaining how traders identify arbitrage opportunities, calculate potential profits, and execute trades to benefit from market mispricings.

Identifying Arbitrage Opportunities

Arbitrage opportunities arise when identical or closely related assets have different prices in different markets. In the context of commodity forwards, a common arbitrage scenario involves spotting a mismatch between the current forward price and the expected future spot price. If the forward price is significantly lower or higher than the projected spot price at maturity, an arbitrage opportunity might exist.

Calculating Potential Arbitrage Profit

To calculate the potential arbitrage profit, traders compare the mispriced forward contract with the expected spot price at maturity. Suppose the forward price is lower than the projected spot price (backwardation). In that case, a trader could buy the cheaper forward contract, take delivery of the commodity upon maturity, and sell it in the spot market at the higher spot price. The profit would be the difference between the forward and spot prices, minus any transaction costs.

Exploiting Pricing Inefficiencies

Arbitrage activities are driven by the pursuit of risk-free profits. Traders act swiftly to exploit pricing inefficiencies, as market forces eventually correct these imbalances. As arbitrageurs buy or sell mispriced assets, their actions push prices back toward equilibrium. This activity contributes to market efficiency and prevents significant deviations between forward and expected spot prices.

Example: Suppose an agricultural commodity has a forward price of $150 per unit for a contract maturing in six months. Based on supply and demand fundamentals, analysts project the expected spot price at maturity to be $170 per unit. This discrepancy signals a potential arbitrage opportunity. A trader could enter a long position in the forward contract, invest $150, take delivery of the commodity at maturity, and sell it in the spot market for $170. The profit would be $20 per unit, minus any transaction costs.