The cost of carry plays a crucial role in identifying and exploiting arbitrage opportunities in financial markets. It represents the total expenses incurred to hold an asset over time, including interest rates, storage costs, insurance, and dividends. Arbitrage opportunities often arise when there is a price discrepancy between the spot market and the futures or forward market for an asset.

According to the cost-of-carry model, the theoretical futures price is determined by adding the cost of carry to the spot price of the asset. If the actual futures price deviates from this theoretical value, arbitrageurs can step in to profit from the mispricing. For example:

1. If futures are overpriced: Arbitrageurs can sell the futures contract, buy the asset in the spot market, and hold it until the futures contract matures. The cost of carry ensures the total cost remains lower than the futures price, enabling a profit.

2. If futures are underpriced: Arbitrageurs can sell the asset in the spot market and simultaneously buy the futures contract, benefiting when prices converge.

This relationship ensures that arbitrage activities correct pricing inefficiencies, bringing futures prices in line with their theoretical values. However, high transaction costs or changes in market conditions can limit arbitrage effectiveness.