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  • Arbitrage - an example

     
     

    The most common form of arbitrage for coffee is the robusta/arabica quality spread because the two major futures markets clearly show the arbitrage value, New York being arabica based and London robusta. If the price difference between two comparable arabica and robusta delivery positions is considered overstated or understated then the arbitrageur will buy the one and sell the other according to their convictions, speculating that the difference will move in their favour.

    Trade houses for the most part go far beyond simple robusta/arabica arbitraging. Remember, there are over 60 countries that produce hundreds of different qualities and types of coffee. A good trader will look to all the quality options. Perhaps they will buy Brazil coffee trading at 8 cts/lb under New York 'C', while selling short Colombians at plus 12 cts/lb New York 'C', arguing that, comparatively speaking, Brazil is cheap and Colombians expensive. This sounds good, but in recent years it has been entirely possible to lose on both sides of such an arbitrage.

    There are other forms of arbitrage. One that is very common in an oversupplied market is the 'cash and carry'. When the spot position is at a discount, high enough to cover the costs of carrying inventory to the next delivery period, this is called a 'cash and carry'. A 'cash and carry' in itself is not an arbitrage, but when the costs to carry are different for different markets, one can arbitrage the variation in carry costs.

    Example: The carry cost for the NYKC September to December is based upon the following costs:

    • Financing (cost of money);
    • Insurance;
    • Storage;
    • Weight discounts (0.5% after the first two months of storage, 0.125% for each month stored after that);
    • Age discounts (0.5 cents or 50 points for the first 150 days, after that 25 points per month for the first year, 50 points per month for the second year, 75 points per month for the third year, and 100 points per month for coffee over three years).

    The costs for a simple August shipment of cash market coffee on 'cash and carry' basis, September through December, are all of the above, except for any quality discounts. Depending upon the type of coffee and its actual arrival date, there might be no weight discount. One can take delivery of fresh coffee in September and deliver it on in December without a discount. It is thus possible to arbitrage the cash market 'cash and carry', which is approximately 2.5 cts/lb, with the futures market 'cash and carry' of approximately 4 cts/lb based upon the average age of the certificates. In this example, a trader can pick up 1.5 cents for every pound of coffee carried from September to December.

    • In August buy fresh coffee at September less 1 ct/lb.
    • Simultaneously sell the same coffee at December less 1 ct/lb.
    • September/December is trading at 4 cents: the cash and carry for the futures market.
    • Effectively the trader bought fresh coffee September delivery at a 4 cent discount to the price they sold December.
    • It costs 2.5 cts/lb to carry the coffee from September to December in the cash market (storage, interest, and insurance only) leaving the remaining 1.5 cts/ lb as profit.
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