What Is Cost of Carry?
Cost of carry refers to costs associated with the carrying value of an investment. These costs can include financial costs, such as the interest costs on bonds, interest expenses on margin accounts, interest on loans used to make an investment, and any storage costs involved in holding a physical asset.
Cost of carry may also include opportunity costs associated with taking one position over another. In the derivatives markets, cost of carry is an important factor for consideration when generating values associated with an asset’s future price.
Understanding Cost of Carry
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 also create arbitrage opportunities.
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 an investor foregoes over a period of time including things like cost of physical inventory storage, insurance, and any potential losses from obsolescence.
Each individual investor may also have their own carrying costs that influence their willingness to buy in the futures markets at different price levels. The futures market price calculation also takes into consideration convenience yield, which is a value benefit of actually holding the commodity.
- F = Se ^ ((r + s - c) x t)
- 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.
Other 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.
- Cost of carry is a factor in both direct investing and derivative markets.
- Carrying costs detract from total return for direct investors.
- In the derivative markets, carrying costs are a factor that influence derivative contract pricing.
Net Return Calculations
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, incorporating carrying costs into net return calculations can be an important part of return due diligence since it will inflate returns if overlooked. 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 primary costs that detract from total returns.