What is the Cost of Carry?

Cost of carry refers to the total expense involved in holding or carrying an asset or position over a period of time until it is sold or settled. These costs may include financing charges, storage costs, insurance, and other holding-related expenses. In financial markets, the concept is commonly associated with derivatives such as futures, where the price difference between the spot price and futures price may reflect these carrying costs. The following sections explain the cost of carry model, formula, examples, and its role in derivatives and futures. 

What Is the Cost of Carry Model? 

The cost of carry model is a financial concept that explains how the price of a futures contract may relate to the price of the underlying asset. It considers the expenses and benefits associated with holding an asset until the futures contract expires. Key points that explain what is cost of carry in stock market include: 

• It assumes that the futures price is influenced by the cost of holding the underlying asset until the contract’s expiry date. 
• The model considers financing costs, such as interest paid on borrowed funds used to purchase the asset. 
• It generally also includes storage or maintenance costs, particularly for commodities that require physical storage. 
• In some cases, income from the asset, such as dividends, may reduce the total cost of carry. 
• The model is often used to estimate the theoretical futures price of an asset. 
• Differences between the theoretical price and the market price may also provide possible arbitrage opportunities. 
• In simple terms, the cost of carry model provides a framework for understanding how holding costs and income factors can influence futures pricing. 

Cost of Carry Formula with an Example 

The cost of carry formula is commonly used to estimate the theoretical price of a futures contract based on the current spot price and the cost of holding the asset.  

The cost of carry formula is:  

F =Se^(r+s-c)*t) 

Where: 

Each component of the formula represents the following: 

• F (Futures Price) 
  This refers to the price at which the commodity or asset is expected to be traded in the future according to the theoretical calculation. 
• S (Spot Price) 
  This represents the current market price of the commodity or underlying asset in the spot market. 
• e (Natural Log Base) 
  The value e is a mathematical constant used in continuous compounding calculations. It is approximately equal to 2.718 and is commonly used in financial models involving time-based growth. 
• r (Risk-Free Interest Rate) 
  This indicates the interest rate that can typically be earned from a risk-free investment over the same period. It represents the financing cost of holding the asset. 
• s (Storage Cost) 
  Storage cost refers to the expenses involved in storing the commodity until the delivery date. It is usually expressed as a percentage of the spot price. 
• c (Convenience Yield) 
  Convenience yield represents the benefit or advantage of physically holding the commodity instead of holding a futures contract. It may arise when immediate access to the commodity is valuable for production or operational purposes. 
• t (Time to Delivery) 
  This refers to the time remaining until the futures contract is delivered or expires. It is generally expressed as a fraction of a year. 

Let’s understand the formula using a simple example: 

• Assume the script ABC is trading at 4000 in the spot market. 
• The prevailing annual interest rate is 20%. 
• The futures contract has one year remaining until expiry. 

Using the formula: 

• Spot price (S) = 4000 
• Risk-free interest rate (r) = 20% per year (0.20) 
• Storage cost (s) = 5% per year (0.05) 
• Convenience yield (c) = 2% per year (0.02) 
• Time to expiry (t) = 1 year 
• e (natural log base) ≈ 2.718 

F = 4000 × e^(0.20 + 0.05 − 0.02) × 1 

In this hypothetical example, the theoretical futures price may be approximately 5032 based on the cost of carry formula. 

Futures Cost of Carry Model 

In the futures market, the cost of carry model is often used to understand the relationship between spot prices and futures prices. Key aspects generally include: 

• Futures prices may reflect the spot price adjusted for carrying costs until the contract expires. 
• These carrying costs may include interest expenses, storage costs, or insurance. 
• If the underlying asset generates income such as dividends, it may reduce the overall cost of carry. 
• The model may help identify whether the futures price is higher or lower than the spot price based on market conditions. 
• Traders and analysts often use this concept to evaluate pricing efficiency in futures markets. 

Cost of Carry in Derivatives

The concept of cost of carry plays an important role in several derivative markets. Important points generally include: 

• It helps explain the pricing relationship between derivatives and their underlying assets. 
• Futures contracts are commonly analysed using cost of carry principles. 
• The cost of carry may include interest, storage, insurance, or opportunity costs associated with holding the asset. 
• If the asset produces income such as dividends or yields, it may offset part of the carrying cost. 
• Analysts may use cost of carry concepts to compare spot prices with derivative prices. 

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. 

Conclusion 

Cost of carry is an essential term that can be used to understand how futures contract prices can be related to their underlying assets. By considering different factors such as interest rates, storage costs, and income generated by an asset, investors can effectively understand how futures and spot market prices can differ. While the concept is widely used in derivatives analysis, actual market prices may vary due to demand, supply, and market expectations. Understanding such concepts can enable individuals to clearly understand futures pricing while using an online trading app.