What is the Cost of Carry?
- 24 Jun 2024
- By: BlinkX Research Team
The cost of carry model is all about the costs you face while keeping your investments for a particular time. It can be the interest you pay on a loan or the missed opportunities when you switch investments, the Cost of Carry covers it all. Understanding what is cost of carry in stock market is like opening a secret code to make wise investment choices and manage your money better. Let’s understand the cost of carry in depth and how it works.
Cost of Carry in Derivatives
The cost of carry in derivatives is a measure of the actual costs of an investment or position, based on the difference between the cost of an asset and its return over time. It is commonly used in the pricing of futures contracts and the difference between the yield earned on a cash asset and its cost of funding. The cost of carry formula includes the physical cost of holding assets, insurance payments, and interest expense on margin accounts. It is important to consider the cost of transportation, as traders may have a greater interest in storing futures contracts as their value increases.
Table of Content
- Cost of Carry in Derivatives
- How Can I Calculate the Cost of Carry?
- Understanding the Importance of Cost of Carry
- Futures Cost of Carry Model
- Calculating Cost of Carry in Futures
- What is the Cost of Carry Model?
- Cost of Carry Formula with an Example
- Can the Cost of Carry be Negative?
- How is the Cost of Carrying Observed in the Market?
How Can I Calculate the Cost of Carry?
To calculate the cost of carry you can use this formula:
Futures price = Spot price + cost of carry
Cost of carry = Futures price – spot price.
Understanding the Importance of Cost of Carry
The cost of carry is important in many financial areas so don’t just take it as a random number. The value of the cost of carry depends on the expenses linked to maintaining a specific position. However, it has the drawback of sometimes affecting the trading demand and creating fewer opportunities.
Futures Cost of Carry Model
The Cost of Carry Futures Model calculates the future price of a financial asset based on the cost of holding that asset until the expiration date specified in a futures contract. This model considers several key factors: the current spot price of the asset, the risk-free interest rate, storage costs, and any convenience yield (the benefit of holding the physical asset rather than the contract). By incorporating these elements, the model provides a comprehensive estimate of the asset's future price.
Calculating Cost of Carry in Futures
Here is the breakdown of the formula:
F = Se ^ ((r + s - c) x t)
Here's what each symbol represents:
F = future price of the commodity
S = spot price of the commodity
e = 'base e', a mathematical constant (around 2.718)
r = risk-free interest rate
s = storage cost (as a percentage of the spot price)
c = convenience yield
t = time to delivery of the contract (as a fraction of one year)
What is the Cost of Carry Model?
You need to learn the cost of the carry model before understanding the concept of carrying costs. This model operates on the idea that all pricing differences between current and future prices are balanced out by trading between them, erasing any profit opportunities. The only item justifying the difference between the spot and the futures prices is the cost of carry after considering all these other factors.
The cost of maintaining a futures position on your books is implied by its name. The cost of carry model assumes that these futures contracts are held until maturity without being squared off.
Cost of Carry Formula with an Example
The amount of the current spot prices and transport costs are usually referred to as the price of a futures contract. However, the related assets' demand and supply also determine the contracts' actual price.
To determine the target value, a cost-of-carrying calculator may be applied. The formula for calculating this cost is as follows:
- The Cost of Carrying = The price of the futures contract – The spot price of the futures contract
- (Futures price = spot price of the underlying security + cost of carry)
- To understand this concept better, we'll look at the cost of carrying an example: Let's assume the script ABC is at 2000 and the prevailing interest rate is 10% annually.
- P = 2000+2000*0.10*30*365, the future price for a month's contract.
- This will be P = 2000+ 16.43 = 2016.43.
- Consequently, it is 16.43 for the costs of transport incurred.
Can the Cost of Carry be Negative?
Yes. A futures contract that trades at a loss relative to the results it represents has a negative cost of carrying. Dividends or "reverse arbitrage" strategies, where traders purchase spots and sell futures are the most frequent reasons for this. It indicates a bearish sentiment when carrying costs are negative.
How is the Cost of Carrying Observed in the Market?
Let’s understand the cost of carrying observed in the market with the following table:
Cost of carrying | Open Interest | Indicator | Action |
Increases | Increases | Bullish | Long build-up |
Decreases | Decreases | Cautiously bearish | Long unwinding |
Decreases | Increases | Bearish | Short build-up |
Increases | Decreases | Cautiously bullish | Short covering |
- The cost of carrying, together with open interest, serves to paint a clear picture of the market mood.
- When both the cost of carrying and open interest rise. This is a positive indication. The implication here is that fresh, long positions are being taken in the market. This is known as a long build-up.
- When the carrying cost and open interest both fall. This is a negative sign that should be used with caution. The implication here is that previously made positions are being squared off. This is known as a Long Unwinding.
- When the cost of carrying falls and open interest rises. This is a bearish signal. The implication here is that fresh positions are being created as traders short-sell in the market. This is known as a short build-up.
- When the cost of carrying rises while the open interest falls. This is a somewhat positive indication. The implication here is that the previously taken short bets are now being covered. This is known as a Short Covering.
Conclusion
Carrying costs, also known as storage or retention charges, are associated with physical products and financial instruments. These costs can influence investors' investment decisions, with physical commodities often carrying higher costs than financial assets. BlinkX is an online trading app designed for ease and accessibility, offering a user-friendly interface, robust features, and the ability to open a free demat account. It also provides real-time market alerts.