Cost of carry

Definition

Cost of carry refers to the costs associated with holding a physical asset or a financial instrument over a period of time. This includes storage costs, financing costs (like interest), and any income generated from the asset, such as dividends or interest income. Understanding the cost of carry is crucial for pricing forward and futures contracts, as it influences the relationship between spot prices and futures prices.

5 Must Know Facts For Your Next Test

1. The cost of carry is critical in determining the futures price of an asset, which is typically calculated using the formula: Futures Price = Spot Price + Cost of Carry.
2. If the cost of carry is high, futures prices will be higher compared to spot prices, reflecting the additional costs involved in holding the asset.
3. In a situation where an asset generates income (like dividends), this income can reduce the overall cost of carry, potentially leading to lower futures prices.
4. The concept applies not only to commodities but also to financial instruments like stocks and bonds, influencing trading strategies and investment decisions.
5. Understanding cost of carry helps traders identify arbitrage opportunities when discrepancies arise between spot and futures prices.

Review Questions

• How does the cost of carry impact the pricing of futures contracts compared to spot prices?
  • The cost of carry significantly influences futures pricing because it accounts for all costs associated with holding an asset until the delivery date. When calculating futures prices, the formula includes both the spot price and the cost of carry. If holding costs are high, this results in a higher futures price compared to the spot price. Conversely, if costs are low or if the asset generates income, this can lower the futures price, creating dynamics that traders must understand for effective decision-making.
• Discuss how changes in interest rates can affect the cost of carry and subsequently impact futures pricing.
  • Changes in interest rates have a direct effect on the cost of carry since financing costs are a significant component. If interest rates rise, the cost of borrowing increases, which raises the overall cost of carry. This higher cost typically leads to increased futures prices relative to spot prices. Conversely, if interest rates decrease, financing becomes cheaper, potentially lowering the cost of carry and thus reducing futures prices. Traders must closely monitor interest rate trends as they directly impact profitability in futures markets.
• Evaluate how understanding the concept of cost of carry can create arbitrage opportunities in financial markets.
  • Grasping the concept of cost of carry allows traders to identify situations where there are discrepancies between spot prices and futures prices that are not justified by carrying costs. If an asset's spot price is significantly lower than its corresponding futures price after accounting for carrying costs, an arbitrageur can buy the asset in the spot market and sell it in the futures market for a profit. Conversely, if futures prices are lower than justified by carrying costs, they can sell futures while buying the underlying asset. This ability to exploit inefficiencies reinforces market equilibrium and demonstrates why understanding cost structures is vital for traders.

Related terms

futures price: The agreed-upon price for a future transaction in a futures contract, determined by the underlying asset's spot price and the cost of carry.

spot price: The current market price at which an asset can be bought or sold for immediate delivery.

arbitrage: The practice of taking advantage of price differences between markets to generate a profit, often involving simultaneous buying and selling of assets.