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  • QA 098
    Question:
    Can exporters take advantage of 'arbitrage' between different futures markets?
    Background:
    We have read how 'arbitrage' between the coffee futures exchanges in Brazil and New York is of importance to exporters of Brazilian coffee. Is 'arbitrage' something that exporters in other countries could or should also use to their advantage?
    Asked by:
    Exporter - Indonesia
     
    Answer:

    As you have read, arbitrage in its simplest form is the forecasting of the future price difference between different but related trading positions on a futures market*. This activity is usually called spread trading and is more fully explained in QA 092 in the Q&A Archive.

    Pure arbitrage though is really carried out between different futures markets and/or between different commodities.Furthermore, such markets may be located in different countries, they may not necessarily trade in the same currency, and in some instances the relationship between the commodities may be the thinnest imaginable. There is the textbook example of the food processor who sees oats trading out of line with wheat. Even though knowing he will in time need oats he buys wheat instead and switches contracts once the differential (the price difference) comes back into line…In to-days energy markets traders play the differentials between gasoline (petroleum), heating oil, and crude oil - this business goes by the name of 'crack spreads' that itself has its origin in the catalytic cracking process that separates oil into different components.

    Returning to our own commodity, in coffee there are no identical futures markets**: New York is based on a basket of different arabica origins, Sao Paulo is based on Brazilian arabica (currently not tenderable in New York - see topic 08.04.02), and London is based on robusta coffee from any origin. However, all three markets trade in the same currency, the US Dollar.

    In general terms exporters are well advised to regularly monitor the price difference between these futures markets. Particularly so with New York and London: if the difference widens too much then cheap robusta could attract some roaster movement away from arabica - if it narrows too much then the opposite could occur.  We could imagine that an exporter trading both arabica and robusta could develop the view that arabica is cheap and robusta expensive (or the other way around). A view he might wish to act upon without necessarily entering into physical purchases of the one and short sales of the other, or by buying call and put options.*** If so then arbitraging the two markets might be an option but do bear in mind that the buying and selling of futures requires access to brokers and good credit lines take care of the inevitable margin calls…

    The same general principle of course applies to the price difference between Brazilian arabica and New York. However, the Brazilian Sao Paulo market reflects the internal value of Brazilian coffee in dollars while the export market is always priced as a differential to the New York C contract.  When Brazilian exporters sell forward export shipments they will buy the Sao Paulo market as a hedge until the physical coffee becomes available. They are confident that the internal physical market will always be reflected in the SP market whereas doing the arbitrage between Sao Paulo and New York ensures the differential is safe.

    Bear in mind that these examples are facilitated by the fact that New York, London and Sao Paulo all trade coffee in US Dollars. Cocoa and other commodities on the other hand are traded in US currency in New York but in Sterling in London… Now the arbitrageur has to deal not only with quality and origin allowance differences between the two markets (the origin specifications and points differences are not the same), but also currency fluctuations. This requires that the arbitrage transaction must be accompanied by the simultaneous purchase of currency cover, something that many traders are unable or unwilling to do. However, for the true arbitrageur the location of the markets is not important whereas dealing in different currencies only makes this more complicated but not at all impossible. The point is that the best arbitrage is between different commodities that have some relationship that can be exploited…

    However, in our view arbitrage is not something exporters should engage in unless it truly assists them to manage price risk. 

    Managing price risk is not the objective of the true arbitrageur who does not really look at the value of the two positions when entering into an arbitrage transaction. Only the price difference between the two positions/commodities counts when placing an order. This is also necessary to avoid only one leg of the transaction being placed if one or the other market moves but it also demonstrates the speculative aspect.

    *
    Arbitrage is often also referred to as straddling or straddle. To describe the exact differences between the two is complicated but below are three technical definitions of arbitrage, the last one being the official version issued by the US Commodity Futures Trading Commission.

    1. Simultaneous purchase and sale of two different contracts (or a combination of cash and futures) to take advantage of perceived mispricing. In a pure arbitrage mispricing is locked in a risk-free profit made through trades.
    2. The purchase of a commodity against the simultaneous sale of a commodity to profit from unequal prices. The two transactions may take place on different exchanges, between different commodities, in different delivery months, or between the cash and futures markets.
    3. A strategy involving the simultaneous purchase and sale of identical or equivalent commodity futures contracts or other instruments across two or more markets in order to benefit from a discrepancy in their price relationship. In a theoretical efficient market there is a lack of opportunity for profitable arbitrage.

    ** 
    InterContinental Exchange - New York,www.theice.com. See section 08.04
    Bolsa de Mercadorias y Futuros - Sao Paulo,www.bf.com.br See section 08.07
    Euronext Liffee - London,www.liffe.com. See section 08.05

    ***
    Call option: Confers the right, but not the obligation, to buy a futures contract at an agreed price  between the date of the option contract and its expiry date.
    Put option:   Confers the right, but not the obligation, to sell a futures contract at an agreed price.
    See section 09.03 for more.

    Posted 07 June 2006
    Updated 03/2009

    Related chapter(s):
    Related Q & A:
    QA 040, QA 054, QA 092