Cost of Carry

Definition

The cost of carry refers to the total cost incurred by holding a financial asset or commodity over a period of time. This includes storage costs, interest on borrowed funds, and any other expenses associated with maintaining the asset. Understanding the cost of carry is essential when dealing with derivatives, as it impacts pricing, trading strategies, and risk management.

5 Must Know Facts For Your Next Test

1. The cost of carry can be calculated using the formula: Cost of Carry = Storage Costs + Financing Costs - Income Generated from Asset.
2. In the context of derivatives, if the cost of carry is high, it may lead to higher futures prices compared to spot prices.
3. The cost of carry influences arbitrage opportunities; traders look for discrepancies between spot and futures prices to exploit differences created by carrying costs.
4. When the market is in contango, it suggests that traders expect higher future prices due to storage and financing costs.
5. Understanding the cost of carry is crucial for traders as it affects their profit margins and can influence their overall trading strategy.

Review Questions

• How does the cost of carry impact trading strategies in derivatives markets?
  • The cost of carry significantly impacts trading strategies in derivatives markets because it directly affects the pricing of futures contracts relative to spot prices. Traders must consider storage and financing costs when making decisions about entering or exiting positions. For instance, if the cost of carry is high, traders might choose to sell futures contracts instead of holding physical commodities, as this could maximize their potential profits by minimizing carrying costs.
• Discuss how contango and backwardation are related to the concept of cost of carry.
  • Contango and backwardation are two market conditions that illustrate how the cost of carry affects futures pricing. In contango, futures prices are higher than current spot prices, which often reflects higher storage and financing costs. Conversely, backwardation indicates that futures prices are lower than spot prices, suggesting that the immediate demand for an asset outweighs carrying costs. Understanding these relationships helps traders anticipate market movements and adjust their strategies accordingly.
• Evaluate the importance of understanding cost of carry for effective risk management in derivative trading.
  • Understanding cost of carry is vital for effective risk management in derivative trading because it influences price dynamics and potential profit margins. Traders need to assess carrying costs to make informed decisions about hedging and speculating. By accurately evaluating these costs, they can better manage exposure to price fluctuations and optimize their portfolio's performance. Additionally, knowledge of how cost of carry impacts market conditions like contango and backwardation enables traders to refine their strategies and mitigate risks associated with derivative instruments.

Related terms

Futures Contract: A futures contract is a standardized legal agreement to buy or sell an asset at a predetermined price at a specified time in the future.

Contango: Contango is a market condition where the futures price of a commodity is higher than the expected spot price at contract maturity, often reflecting the cost of carry.

Backwardation: Backwardation occurs when the futures price is lower than the spot price, indicating that the cost of carry is negative or that there is high demand for immediate delivery.