What is the Cost of Carry?

Derivative trading has become very popular lately. If you too are looking to trade in derivative markets, then understanding the concept of the "Cost of Carry" is very important for you. In a nutshell, it refers to the total cost of holding a particular position in a derivative contract over a period of time until its maturity. This includes various types of costs that an investor incurs to hold the position. The concept of Cost of Carry is particularly significant in futures and commodities trading, where the pricing of futures contracts often involves accounting for the various costs required to maintain the underlying asset. Let us find out more about this concept, including the cost of carry formula.

Understanding the Concept of Cost of Carry

In simple terms, the Cost of Carry is the difference between the current market price – or the spot price – of an asset and the futures price. It represents the net cost that an investor needs to pay to hold a position in the market. This cost can either be positive or negative, depending on the factors influencing the market. A positive Cost of Carry suggests that the futures price is higher than the spot price, while a negative Cost of Carry indicates the opposite. This concept is vital for traders and investors to make informed decisions in the market.

Futures Cost of Carry Model 

The Cost of Carry Model is a foundational concept in futures pricing that helps determine the relationship between the spot price of an asset and its futures price. This model is especially relevant in markets where traders and investors engage in buying and selling futures contracts on commodities, financial instruments, or other underlying assets.

The Cost of Carry includes various elements such as interest costs, storage costs, and any dividends or yields received from the underlying asset. In the case of commodities, storage costs can significantly influence the futures price, while for financial instruments, interest rates play a crucial role. The model assumes that the market is in equilibrium, meaning no arbitrage opportunities exist.

For futures and commodity futures, in particular, the cost of carry formula can be expressed as:

Cost of Carry = Spot Price – Futures Price where spot price of the asset is the current market price at which it can be bought or sold. The spot price serves as the baseline for calculating the futures price.

How to Calculate the Cost of Carry? 

In general, the Cost of Carry formula is:

Cost of Carry = Income from the Asset – (Interest Costs + Storage Costs)

Interest Costs: When an investor opts to purchase an asset using borrowed funds, the interest cost of financing this position is considered part of the carrying cost. Even if the asset is purchased outright, the opportunity cost of not investing the funds elsewhere at a risk-free rate is factored into the model.

Storage Costs: For physical commodities like oil, gold, or agricultural products, storage costs can be significant. These costs include warehousing, insurance, and other expenses required to maintain the asset until delivery. In financial markets, storage costs may be minimal or non-existent, but for commodities, they are a critical component of the Cost of Carry.

Income from the Asset: Some assets, such as stocks or bonds, generate income in the form of dividends or interest. This income can offset the carrying costs, reducing the overall cost of holding the asset. When this income is substantial, it can lead to a negative Cost of Carry, where the futures price is lower than the spot price.

Dividend Payments: In the context of equity futures, expected dividends paid out during the holding period of the futures contract are subtracted from the carrying costs. The more substantial the dividend, the lower the futures price, as investors receive income while holding the asset.

For example, if an investor buys a commodity futures contract, they need to consider the interest paid on borrowed funds and the cost of storing the commodity. If the commodity generates any income, such as dividends, this income would be subtracted from the total cost of carrying the asset.

Can the Cost of Carry Be Negative?

Yes, the Cost of Carry can be negative. A negative Cost of Carry occurs when the income generated from the asset, such as dividends or interest, exceeds the costs associated with holding the asset. In such cases, the futures price may be lower than the spot price. Negative Cost of Carry situations are more common in markets where the underlying asset generates significant income, or the costs associated with holding the asset are minimal.

Cost of Carry in Other Derivative Markets

In financial derivatives, such as stock index futures, the Cost of Carry primarily involves interest rates and dividend yields. For instance, if you are holding a futures contract on a stock index, the Cost of Carry would include the interest cost of holding the index components minus the dividends expected from the stocks in the index. If the dividend yield is higher than the interest cost, the Cost of Carry could be negative, leading to a lower futures price compared to the spot price.

The Cost of Carry is also crucial in arbitrage strategies, where traders exploit price differences between the spot and futures markets. If the Cost of Carry is mispriced, arbitrage opportunities arise, allowing traders to profit from the difference. For example, if the futures price is too high compared to the spot price plus the Cost of Carry, a trader could sell the futures contract and buy the underlying asset, locking in a risk-free profit.

In commodity markets, the Cost of Carry plays a vital role in determining the futures price. Commodities like oil, gold, and agricultural products have storage and insurance costs that must be factored into the futures price. For example, storing crude oil requires significant infrastructure, such as tanks or tankers, which adds to the overall Cost of Carry. Similarly, agricultural products may require specific storage conditions to prevent spoilage, adding to the storage costs.

The Cost of Carry in commodity markets also includes transportation costs, especially if the commodity needs to be moved from one location to another. Additionally, factors like seasonality can impact the Cost of Carry, as storage costs might increase during certain times of the year.

Conclusion

The Cost of Carry is a fundamental concept in derivative and commodity markets, influencing the pricing of futures contracts and impacting trading strategies. By understanding the components of the Cost of Carry, such as interest rates, storage costs, and income from the asset, traders can make more informed decisions and identify potential arbitrage opportunities. Whether you're trading in commodities, stocks, or other financial instruments, keeping an eye on the Cost of Carry is essential for successful market participation.