Cost of Carry

Cost Of Carry Definition

The "cost of carry" is defined as the net cost of holding a position or investment. It is widely used in capital markets to express the difference between the cost of a specific asset and the returns produced on it over a specific period. It is also used for pricing future contracts. 

It helps to study market sentiment for a share or index since a rising cost and open interest show that the market is bullish and traders will pay more for holding futures. Conversely, the falling value implies the opposite. Sometimes, futures trade below the underlying price, making the cost negative.

• The cost of carry is the amount a business spends on holding a security or asset over time. It is the cost of holding and keeping the asset or items on hand.
• The largest portion of a company's carrying costs is capital expenses. It comprises the fee of the money invested in the inventory and the interest added. Therefore, it is always represented as a proportion of the overall value of the inventory held.
• The cost of carrying formula can be given by: Cost = futures price - spot price.

Cost Of Carry Explained

The cost of carry is the additional fund needed to hold certain positions. It changes according to the charges required for maintaining the given position. In the market for commodities, the carrying cost refers to the expenses associated with maintaining an item or asset in physical form, including insurance premiums.

The cost incurred associated with an underlying asset or index up until the futures contract's expiration is known as the "cost of an underlying security or index" in the derivatives market. This cost includes interest payments on margin accounts. In addition, economic costs like opportunity costs related to initial positions are also included.

It evaluates market sentiment for a company's stock or index. Rising carry values and rising open interest indicate that traders are optimistic about the market and willing to pay more to hold futures contracts. Furthermore, the underlying asset's price can be discounted by futures contracts, which sometimes causes the cost to be negative.

This indicates a state of pessimism and a bearish stance on the traders' part. The incident typically occurs when a dividend is anticipated for the stock purchased or when traders use a reverse-arbitrage technique that involves buying in the spot market and selling futures.

All potential costs related to taking a position must be taken into account when making an informed investment decision. For example, longer margin positions may result in higher interest rate payments. Hence caution is advised. Since the cost under discussion is an annualized premium of the futures to cash, buying more futures as opposed to cash typically increases the same. The value increases the difference in the absolute price increase between futures and cash.

Cost Of Carry Model

Large sums of money or enormous liabilities are not usually considered in the cost of carry. In reality, the methods used to manage expenses connected to asset position are usually used to determine the financial cost. The Cost of carry model assumes that price inefficiencies are eliminated by the arbitrage spread between future and current prices. Thus, holding a futures position is expensive.

In the future market of derivatives, however, it is defined as the computation component for the future cost of the stock. The cost is tied to a physically held commodity; the price of the inventory, insurance, storage, etc. Hence these factors are included while computing the carrying value for the investor. Since each investor is different, the specific costs associated with these may be a factor that influences their decision to invest in future markets.

Formula

The price of a futures contract is usually the sum of the current spot prices and the cost of carrying. However, the actual price of the contracts also depends on the associated asset's demand and supply. 

The cost of carry calculator can be used to arrive at the desired value. However, the formula that can be used to calculate the cost is very simple and is given below:

Cost of carrying = futures price – spot price

(Futures price = spot price of the underlying security + cost of carry)

The cost of carry calculator may not always be reliable; hence it is wise to use the formula for finding the value.

Example

Let us look at the cost of carry example to understand the concept better:

Suppose the spot price of scrip "XYZ" is 2000, and the prevailing interest rate is 10% per annum. 

The future price for a month's contract will be P= 2000+2000*0.10*30/365. 

This will be:

P= 2000+16.43=2016.43.

Therefore, the cost of carry incurred will be 16.43.

Frequently Asked Questions (FAQs)

Recommended Articles

This article has been a guide to the Cost of Carry and its definition. We explain its model, formula, and example to help understand the concept. You can also go through our recommended articles on corporate finance -

• Cost Management
• Total Cost of Ownership
• Holding Cost