Stock / Share Market
by 5paisa Research Team Last Updated: 2022-11-29T11:45:21+05:30

Introduction

An asset's futures price is usually higher than its spot price (or cash price). The futures price generally accounts for the cost of buying, financing, storing, and insuring the commodity or asset for the seller. Cost of carry is the term used to describe these costs. Let’s understand the cost of carry definition and how it works in detail.

What Is the Cost of Carry?

Simply put, the cost of carry or CoC refers to the net cost of holding a position. Capital markets use this term to define the difference between the cost of an asset and its return over time. It is the most widely used model for pricing futures contracts. This term also describes the difference between the yield generated on a cash asset and the cost of financing it.

The cost of carry formula: Cost of carry = Futures price – spot price.

CoC in the commodity market is the physical cost of holding an asset, including insurance payments. CoC in derivatives markets includes interest expenses on margin accounts, which are charges incurred on underlying securities and indexes until the expiration of the futures contract. 

It is important to pay attention to the Cost of Carry, as the higher its value, the more likely traders are keen to pay for holding futures contracts.
 

Understanding the Cost of Carry

As mentioned above, physical commodities and stocks have different implications regarding the cost of carry. When it comes to physical commodities, CoC includes purchase and transportation costs. Investors may also need to pay to store commodities until they reach a profitable price—something that normally does not apply to stock investments.

Consider this example: Purchasing an INR 200 stock and selling it for INR 250 after one year would result in a profit of INR 50 minus commissions. Imagine you purchased a barrel of oil for INR 200, paid for its transportation to a storage facility, and paid for its storage for INR 10 per month (INR 120 per year); those are your costs of carry. One year later, you sold it for INR 250. This would leave you with a profit of INR 250 minus your purchase price (INR 200), commissions, and transport and storage costs.

There can be ambiguity in the cost of carry across markets, influencing trading demand and creating trading opportunities. 

Futures Cost of Carry Model

Now that you know the cost of carry definition, let’s understand the future cost of carry model.

Cost of carry is a component of the futures and forward price calculations in the derivatives market. Physical commodities typically involve expenses related to the storage costs that an investor eliminates over time, including storage of physical inventory, insurance, and any potential losses.

The carrying costs of each investor may also influence their willingness to buy at different price levels in the futures markets. Convenience yield, which is a valuable benefit of holding the commodity, is also taken into account when calculating futures market prices.

F = Se ^ ((r + s - c) x t)

Where:
●    F = the price of the commodity in the future
●    S = the commodity's spot price
●    e = natural log base, approximation 2.7181
●    r = rate of interest that is risk-free
●    s = storage cost (calculated as a fraction of the spot price)
●    c = the convenience yield
●    t = the time to deliver the contract, expressed in fractions of a year

Using the model, one can understand the relationship between various factors that affect a price in the future.

Example:
Let’s assume that the spot price of scrip X is Rs 1,500 and that the current interest rate is 8 per cent. As a result, the price of a one-month future would be as follows:

F= 1,500 + 1,500*0.08*30/365 = Rs 1,500 + Rs 9.86 = 1,509.86

The cost of carry here is Rs 9.86.
 

Can the Cost of Carry Be Negative?

Yes. A futures contract trading at a discount to the underlying results is a negative cost of carrying. The most common reasons for this are dividends or when traders are conducting "reverse arbitrage" strategies, which involve buying spot and selling futures. When carrying costs are negative, it indicates that the sentiment is bearish.

Other Derivative Markets

Many other scenarios can also exist in derivatives markets beyond commodities. Different markets use different models to calculate and evaluate derivative prices. 

If the cost of carry factors exist for an underlying asset, they will be incorporated into any derivative pricing model. For European and American options, the Black-Scholes Option Pricing Model and the Binomial Option Pricing Model help identify the values associated with option prices.
 

Net Return Calculations

Cost-of-carry factors influence investors' actual net returns across investment markets. Most of these costs are similar expenses foregone when pricing derivatives.

Direct investors should consider carrying costs when calculating net returns. If left out, they can inflate returns. Investors should consider several factors that affect cost-of-carry:

●    Margin: Since a margin is a borrowing factor, it can require interest payments. This would require subtracting interest and borrowing costs from total returns.
●    Short Selling: Investors may want to account for foregone dividends as an opportunity cost when short selling.
●    Other Borrowing: The interest payments on a borrowed loan can be considered a carrying cost that reduces the total return on investment.
●    Trading Commissions: The total return achieved will be reduced if trading costs involve entering and exiting positions.
●    Storage: Investors must account for physical storage costs in markets where assets are stored physically. Among the primary costs that detract from total returns for physical commodities are storage, insurance, and obsolescence.
 

Conclusion

A commodity or security's cost of carry can affect an investor's investment decision, regarding how much they would expect to pay for it and how it compares to other investments. Compared to other financial assets like stocks, physical commodities may have a higher cost of carry.

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