What is the Cost Of Carry
The cost of carry refers to costs incurred as a result of an investment position. These costs can include financial costs, such as the interest costs on bonds, interest expenses on margin accounts, and interest on loans used to purchase a security. They can also include economic costs, such as the opportunity costs associated with taking the initial position.
BREAKING DOWN Cost Of Carry
Cost of carry may not be an extremely high financial cost if it is effectively managed. For example, the longer a position is made on margin, the more interest payments will need to be made on the account. When making an informed investment decision, consideration must be given to all of the potential costs associated with taking that position. In capital markets, the cost of carry is the difference between the yield generated from the security and the cost of entering and maintaining the position. In the commodities markets, the cost of carry includes the cost of necessary insurances and the expense of storing the physical commodity over a period of time.
The Cost of Carry Model
There is a financial model that is used in the forwards market to determine the cost of carry (if the forward price is known), or the forward price (if the cost of carry is known). While this works for forwards, it provides a good approximation for futures prices as well. The formula is expressed as follows:
F = Se ^ ((r + s - c) x t)
F = the forward 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, which is an adjustment to the cost of carry
t = time to delivery of the contract, expressed as a faction of one year
This model expresses relationship between the forward price, the spot price and the cost of carry. For example, assume that a commodity's spot price is $1,000. There is a one-year contract available, the risk-free rate is 2%, the storage cost is 0.5%, and the convenience yield is 0.25%. The equation would be set up as follows:
F = $1,000 x e ^ ((2% + 0.5% - 0.25%) x 1) = $1,000 x 1.0228 = $1,022.80.
The forward price of $1,022.80 shows that the cost of carry in this situation is 2.28%, ($1,022.80 / $1,000) - 1.