Market Structure
Theorists sometimes contemplate conditions of a perfect market. It does not exist. A market that involves transaction costs, carrying costs, firms trying to limit their risks, individuals trying to increase their profits, and all subject to the uncertainty of nature and nations, is going to be considerably less than perfect. In order to make informed choices, a trader needs to understand the market.

SEE: Intro To Open Interest In The Futures Market

Normal Markets
A carrying charge is the cost to have a good on hand from one point in time until another point in time. There are three types of carrying charges:

  1. Storage
  2. Insurance
  3. Financing

*Transportation costs are not considered carrying charges.Regardless of the underlying product, storage and insurance costs are generally the least significant. Considering that financial data are intangible and can be stored and backed up on inconsequentially small disks, it is no surprise that currency, index and interest rate futures require virtually no storage costs. These costs will be higher for agricultural products that need to be held in warehouses, but then again square footage in the farm belt is still quite inexpensive. Insurance, although required for virtually any business dealings, is generally a small factor.

Transportation for financial instruments could range from nothing for an e-mail to a few dollars for a wire transfer. It is different for physical commodities, however. There is a cost to move frozen concentrated orange juice from Florida to Alberta, or crude oil from the North Sea to Italy.

Consistently, the most significant carrying cost is financing. Among futures traders, it is usually set equal to a short-term benchmark called the repurchase or repo rate. The repo is usually quoted at a slight premium over the Treasury bill, because the futures contract itself serves as collateral and the players are often money-center banks with impeccable creditworthiness. Typically, the repo is quoted as an overnight rate.

Unless otherwise stated, we shall assume that, for purposes of the Series 3 exam and this study guide, storage, insurance and transportation costs are negligible. That is, the cost of carry equals the repo rate.

LOOK OUT!
Conceptually, carrying costs have one important implication for trading futures under perfect market conditions:

A commodity's future price must be equal to the spot price, plus the carrying costs.

Otherwise, there would be opportunities for cash-and-carry arbitrage, in which a trader buys the good for cash then carries it to the expiration date (if the futures price is too high) or sells the good short and buys it back on the expiration date (if the futures price is too low).

A corollary to this rule is that a commodity's distant future price must be equal to the near futures price, plus the carrying costs – for exactly the same reasons.

If a commodity's future price is equal to the spot price plus carrying costs, and its distant future price is equal to its near futures price plus carrying costs, then the market is said to be at "full carry." If the futures price is higher, it is said to be above full carry and if lower, it is below full carry.

LOOK OUT!
It is a three-step process to determine if a market is at, above or below full carry.

1. Divide the distant future price by the current spot price or near future price to compute the raw interest rate.

2. Annualize the interest rate.

3. Compare it to the Banker's Acceptance (BA) annualized rate, which is the lowest rate available to most market participants away from the exchange and is usually very close to the repo rate. If a commodity's future price is equal to the spot price plus carrying costs and its distant future price is equal to its near futures price plus carrying costs, then the market is said to be at full carry. If the futures price is higher, it's said to be above full carry and if it is lower, it is below full carry.

For example:
Milk Class IV is the quality of milk used to produce butter and non-fat dry milk. Its futures are traded on the CME.

It is June. Suppose July futures for Milk Class IV settled today at $11.26 per hundredweight and October milk futures settled at $11.53. The 90-day BA rate is an annualized 6.80%.

First, we divide the October price by the July price and get 1.0240 (11.53/11.26). That means the implied interest rate is 2.40% for the three-month period (11.53/11.26 = 1.024 - 1 = .024 x 100 = 2.4%)

Then we annualize the interest rate. From July to October is three months, or one-fourth of the year. So we raise 1.0240 to the fourth power to annualize it to 1.0994. That means the implied annualized rate is 9.94% (1.024).

The BA rate, our proxy for the repo rate, is substantially below that.

The distant futures price, then, is higher than carrying charges can account for, so the market for Milk Class IV is above full carry.

Inverted Markets

Related Articles
  1. Investing

    Explaining Carrying Cost of Inventory

    The carrying cost of inventory is the cost a business pays for holding goods in stock.
  2. Trading

    How & Why Interest Rates Affect Futures

    There are at least four factors that affect change in futures prices, including risk free-interest rates, particularly in a no-arbitrage environment.
  3. Trading

    Contango Vs. Normal Backwardation

    Learn about the futures curve and what its shape means for hedgers and speculators.
  4. Investing

    What Happens to Hedge Funds if Trump Kills the Carried Interest Tax Break?

    Trump's latest tax plan suggestions hint at changes to corporate tax rate but leaves carried interest break unaddressed.
  5. Investing

    What Does Contango Mean?

    Contango​ is when the futures price of a commodity is higher than the expected future spot price.
  6. Investing

    Understanding Carrying Value

    Carrying value is the value of an asset as listed on a company’s balance sheet. Carrying value is the same as book value.
  7. Trading

    Using Index Futures To Predict The Future

    Want to know whether the stock market will open up or down? Check out the index futures.
  8. Investing

    The Credit Crisis And The Carry Trade

    When boom times turned to bust, these trades proved devastating for traders and the broader markets.
  9. Trading

    Advantages Of Trading Futures Over Stocks (APPL)

    We look at the top eight advantages of trading futures over stocks.
Frequently Asked Questions
  1. How do I find historical prices for stocks?

    Historical stock prices help investors evaluate a company's performance in the public markets over time, and can be a valuable ...
  2. What is the history of the S&P 500?

    Discover the history of the S&P 500, which sophisticated market participants consider to be the best index to understand ...
  3. What is the formula for calculating weighted average cost of capital (WACC) in Excel?

    Learn about the weighted average cost of capital (WACC) formula and how it is used to estimate the average cost of raising ...
  4. Where do most fund managers get their market information?

    Many fund managers, whether they manage a mutual fund, trust fund, pension or hedge fund, have access to resources that the ...
Trading Center