General Theory - 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
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:
*Transportation costs are not considered carrying charges. 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.
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.
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.
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.
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.
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.