What is ‘Cost of Carry’ and How to Calculate It?
The cost associated with holding the investment instrument is termed as cost of carry. When an investor invests in security, they need to pay a cost to maintain the security position. These costs can include a multitude of expenses, such as interest payments on bonds, overnight funding charges, interests on forex transactions and margin accounts, commodity storage costs, etc. For instance, if an investor buys a security on margin, they must pay for interest expenses on the funds bought.
The cost of carry plays a vital role in computing the future price of an asset in the derivatives market. Read on to understand how.
How Does the Cost of Carry Work?
Investors must put in the effort to carefully analyze and identify all potential costs if they choose to invest in a position. While there may be a variety of costs included, the cost of carry is not necessarily an exorbitant sum.
It also doesn’t mean that the investor’s liabilities will increase significantly. The strategies used to manage and minimize potential costs determine the extent of financial costs.
The definition of cost of carry varies based on context. For example, maintenance costs are not included in the cost of carry when considering capital markets. However, storage, insurance, maintenance, and other incidental costs make the cost of carry in commodity markets.
Importance of Cost of Carry Model
Understanding the cost of carry model is vital to analyze the true cost of an asset.
The model is built on the assumption that the arbitrage spread that distinguishes the current price of an asset and the futures price helps eliminate all the pricing imperfections. Thus, after removing the other factors, the cost of carrying is the only factor responsible for the difference between the spot price and the futures price. The model also assumes that people hold futures contracts till the expiry date and do not square them off before that.
According to the model, the futures price is calculated as below:
Futures Price = Spot price of the asset + Net cost of carrying till expiry
The risk increases with the expiry period, and so does the cost of carrying.
Here is a quick overview of the components of the cost of carrying:
The net cost of carrying comprises all the expenses that an investor may have to bear if they were to retain a similar position in the cash market. However, all dividends, bonuses, and other returns are subtracted from these costs to adjust them. Thus, the components that typically make the cost of carrying include financing expenses in the case of using borrowed money to secure a cash position, opportunity costs if the investor uses their own money to take a cash position, and adjustments for returns.
One must use index dividend yield as a benchmark if one wishes to approximate dividend returns for index futures.
The significance of the cost of carrying model is that it points to the costs and advantages that a trader comes across when choosing not to close the positions they hold in the cash market. In such cases, the futures prices make up for these costs.
Cost of Carry Formula
The formula for calculating cost of carry is:
F = Se ^ ((r + s – c) x t)
Where:
- F is the commodity’s future price
- S is its spot price
- e is the base of natural logs, approximated as 2.718
- r is the risk-free interest rate
- S is the storage cost, which is expressed as a percentage of the spot price
- c is the convenience yield
- t is the time to contract delivery, which is expressed as a fraction of a year
How is the Cost of Carry Calculated?
The cost of carry is calculated using the equation below:
Cost of carry = Futures price – Spot price
The calculations express the cost of carry as an annualised rate in percentage form. Investors can find the real-time cost of carry values from stock exchange websites.
Example:
Here is an example of the cost of carry calculation:
The spot price of a commodity is Rs.2000, and the interest rate is 8% per annum. If we wish to calculate the futures price of the contract (1 month), it is calculated as –
2000 + 2000 * 0.08 * 30/365 =2000 + 13.15 = 2013.15.
Thus, the cost of carrying is Rs.13.15
How is the Cost of Carry Interpreted?
The value of the cost of carry helps to assess the market sentiment and predict the future marker movement. A low value of the cost of carry indicates a downward trend in the value of underlying security, whereas a higher value points to an upward trend.
What is the Cost of Carry Futures?
In the derivatives futures market, the cost of carry is an important constituent that helps compute a stock’s future value. If the commodity on which the cost of carry applies is a physically retained asset, the cost of carrying can include insurance, storage costs and inventory pricing.
Investors have varying investment approaches, and thus each investor’s unique considerations will influence their decision to invest in the futures market.
How Does the Cost of Carry Represent Bullishness or Bearishness?
The numerous changes in the open interest and the cost of carry represent how the financial instrument under consideration is performing in the market. Open interest refers to the total open positions in the contract. If the cost of carry increases substantially, this will mean longer and bullish positions, whereas a drastic decline in the cost of carry will mean bearishness.
Similarly, if the investor observes a decline in open interest along with an increasing cost of carrying, they can conclude that short positions are being closed by a large number of traders. On the other hand, if they see a decline in open interest along with a decrease in the cost of carry, it will mean that a majority of traders are selling long positions.
According to analysts, the cost of carry also changes notably as the derivatives contract nears its expiry. There is also a common belief that if a significant number of front-month contracts close to expiration are being switched out to another contract in a later month (rollover) at a higher carrying cost, the market is bullish.
How Does the Cost of Carry Affect Net Return?
The cost of carry of any investment has a significant impact on its net return. This makes it imperative for investors to keep track of all charges that make up the cost of carrying. Ignoring it may lead them to incur exorbitant charges and thus decrease their net profit.
Final Word
Cost of carry is an important concept that all traders and investors must be aware of. In the absence of an effective strategy to control the cost of carry, it may lead to high costs that may reduce the net returns on the investment. It is an important metric because it also indicates the market sentiment and helps to determine whether the market is bullish or bearish.
FAQs
Ans: Several financial products are affected by the cost of carry, but the most impact is seen on Forex and commodities markets. Derivatives markets also see a significant impact of the cost of carry.
Ans: The price of derivatives is based on the spot price of the underlying security and thus moves in sync with it. However, the result may also be different. Since futures prices may change and widen the arbitrage spread, they may become more attractive to investors and increase spot prices.
Ans: Yes, the cost of carry can have a negative value. This happens when the trading price of futures is lower than the price of the underlying security. There are 2 primary reasons for this occurrence. The first is that a dividend payment is on the cards for the stocks, and the second is that traders are actively buying stocks and selling futures. This is known as the reverse arbitrage strategy.
Ans: The value of the cost of carry helps to understand market sentiment and predict future movement.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
