Understanding Cost of Carry: Key Definitions, Models, and Factors

What Is Cost of Carry?

Cost of carry involves expenses tied to maintaining an investment, impacting the total return for investors. It comprises financial costs like interest on margin accounts and loans, storage costs, and opportunity costs. In derivative markets, it plays a crucial role in determining future asset pricing, influencing trading demands, and creating arbitrage opportunities.

How Cost of Carry Impacts Financial Investments

Cost of carry can be a factor in several areas of the financial market. As such, cost of carry will vary depending on the costs associated with holding a particular position. Cost of carry can be somewhat ambiguous across markets, which can have an effect on trading demand and may create arbitrage opportunities.

Exploring the Futures Cost of Carry Model

In the derivatives market for futures and forwards, cost of carry is a component of the calculation for the future price as notated below. The cost of carry associated with a physical commodity generally involves expenses tied to all of the storage costs that an investor foregoes over a period of time, including things like cost of physical inventory storage, insurance, and any potential losses from obsolescence.

Each investor may have unique carrying costs that affect their willingness to buy futures at various prices. The futures price calculation also considers the convenience yield, a benefit of holding the commodity.

• F = Se ^ ((r + s - c) × t)

Where:

• F = the future price of the commodity
• S = the spot price of the commodity
• e = the base of natural logs, approximated as 2.718
• r = the risk-free interest rate
• s = the storage cost, expressed as a percentage of the spot price
• c = the convenience yield
• t = time to delivery of the contract, expressed as a fraction of one year

This model expresses the relationship between different factors influencing a future price.

Cost of Carry in Various Derivative Markets

In other derivatives markets beyond commodities, many other scenarios can also exist. Different markets have their own models for helping to calculate and evaluate prices involved with derivatives.

Any derivative pricing model involving a future price for an underlying asset will incorporate some cost of carry factors if they exist. In the options market for stocks, the Binomial Option Pricing Model and the Black-Scholes Option Pricing Model help to identify values associated with option prices for American and European options, respectively.

Calculating Net Returns With Carrying Costs

Across the investment markets, investors will also encounter cost of carry factors that influence their actual net returns on an investment. Many of these costs will be similar expenses considered as foregone in derivative market pricing scenarios.

For direct investors, including carrying costs in return calculations is crucial because overlooking them inflates returns. There are several cost of carry factors that investors should account for:

• Margin: Using margin can require interest payments, since a margin is essentially borrowing. As such, interest borrowing costs would need to be subtracted from total returns.
• Short selling: In short selling, an investor may want to account for foregone 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 total return.
• Trading commissions: Any trading costs involved with entering and exiting a position will reduce the overall total return achieved.
• Storage: In markets where physical storage costs are associated with an asset, an investor would need to account for those costs. For physical commodities, storage, insurance, and obsolescence are the main costs that reduce returns.

The Bottom Line

Cost of carry encompasses the expenses linked to maintaining an investment position, including interest, storage, and opportunity costs. It plays a crucial role in both direct investing and derivative markets, impacting total returns and derivative contract pricing.

Understanding the cost of carry allows investors to more accurately evaluate net returns and identify arbitrage opportunities. Key factors include margin interest, short selling, storage costs, and insurance. By considering these costs, investors can make more informed decisions about their investments and improve their financial outcomes.