Cost of Carry

What is the Cost of Carry?

The cost of carry is nothing but the costs associated with the carrying value of an investment. These costs can include interest costs on bonds, interest expenses on margin accounts, interest on loans used to make an investment, and any storage costs involved in holding a physical asset. Cost of carry means the interest cost of a similar position in the cash market and carried up to maturity of the futures contract minus any dividend expected till the expiry of the contract. In simple language Cost of carry is the total cost of holding a position. It is the most widely used model to decide the price of futures contracts. The term is used in capital markets to define the difference between the cost of a particular asset and the returns generated on it over a specific time period.

Cost of Carry can also be defined as the difference between the interest generated on a cash asset and the cost of funds to finance that instrument. The definition of Cost of Carry in the commodity market is the cost of holding an asset in physical form, including insurance payments. In the derivatives market, it includes interest expenses on margin accounts, which is the cost collected on an underlying security or index until the expiry of the futures contract. The cost also includes economic costs, such as the opportunity costs related to taking the initial position.

The value of Cost of Carry is used as an indicator to understand the market sentiment i.e. Low Cost of Carry means there is a fall within the value of the underlying asset and the other way around . While making an investment decision, all major costs associated with taking a position should be considered. A longer position on margin attracts higher interest payment.

Futures Cost of Carry Model

The price of a derivative instrument is the sum of the prevailing cash price and therefore the cost of carry. But the particular price of a derivative instrument depends on the demand and provision of the underlying stock. The simple expression for the cost of carry is:

Cost of Carry = Futures price – spot/share price

Futures price = Spot/share price + cost of carry

Cost of carry is used to calculate the price of the future. The cost of carry related to a physical commodity involves expenses related to all of the storage costs an investor gives up over a period of time including things such as cost of insurance, physical inventory storage, and any major losses from being outdated. To calculate the futures exchange price convenience yield which may be a valuable advantage of actually holding the commodity should be considered. Following is the formula to calculate the price of future,

F = Se ^ {(r + s - c) x t}

Where

F = the longer term price of the commodity

S = the cash price of the commodity

e = the bottom of natural logs approximated as 2.718

r = the risk-free interest rate

s = the storage cost expressed as a percentage of the cash price

c = the convenience yield

t = time to delivery of the contract expressed as a fraction of 1 year

This model expresses the effect of different factors on future price. Every derivative pricing model consisting of a future price for an underlying asset must include some cost of carry factors if they exist.

Positive cost of carry

When the future price is greater than the share/spot price then it is called positive Cost of Carry. This is also called as the futures are in the premium. Higher values of the value of carry alongside the build-up of open interest indicate that traders are bullish and willing to pay more for holding futures.

Negative cost of carry

If the future price is less than the share/spot price then it is called positive Cost of Carry. This is also termed as the futures are in discount. The negative cost of carry points to bearish sentiment. This generally happens when the stock is expected to pay a dividend and/or when traders are aggressively executing a “reverse arbitrage” strategy, which involves buying spots and selling futures. The cost of carry increases if one buys more futures than cash. The higher the price difference between futures and cash, the higher is the cost of carry.

Net Return Calculations

In the investment markets, cost-of-carry factors can influence actual net returns on investment of investors. For direct investors, including carrying costs into net return calculations can be an important part of a return due to thoroughness as it will inflate returns if overlooked.

There are many cost-of-carry factors that investors should consider :

Margin

Since a margin is essentially a borrowing, use of it can require interest payments. Interest borrowing costs are needed to be subtracted from total returns.

Short Selling

In short selling, an investor may want to account for fore passed dividends as a type of opportunity cost.

Other Borrowing

When making any type of investment with borrowed funds, the interest payments on the loan can be considered a type of carrying cost that reduces the total return.

Trading Commissions

Any trading costs involved in entering and exiting an edge will reduce the general total return achieved.

Storage

In markets where physical storage costs are related to an asset, an investor would wish to think about those costs.