Cost of Carry

Definition

Cost of carry refers to the total cost associated with holding a physical asset or a financial instrument over a period of time. This includes storage costs, financing costs, and any other expenses related to maintaining the asset until it is delivered or sold. Understanding cost of carry is essential as it directly impacts pricing in forward and futures contracts, where the costs can influence the market's expectation of future prices and guide traders' decisions.

5 Must Know Facts For Your Next Test

1. The cost of carry can be positive or negative, depending on whether the carrying costs outweigh the benefits of holding the asset, like potential appreciation in price.
2. In futures contracts, the cost of carry is reflected in the futures price as it includes storage, insurance, and interest costs.
3. In forward contracts, the calculation typically uses the current spot price adjusted by the cost of carry to determine future pricing expectations.
4. Higher interest rates generally increase the cost of carry, making it more expensive to hold an asset compared to selling it immediately.
5. Understanding cost of carry helps traders assess whether it's more beneficial to enter into a forward or futures contract or take immediate delivery of an asset.

Review Questions

• How does cost of carry impact the pricing of forward and futures contracts?
  • Cost of carry impacts pricing in both forward and futures contracts by influencing how much traders are willing to pay for future delivery. In calculating forward prices, the spot price is adjusted for storage and financing costs associated with holding the underlying asset until contract maturity. In futures contracts, similar adjustments are made, which can lead to variations in pricing depending on market conditions and expectations regarding future price movements.
• Discuss how fluctuations in interest rates can affect the cost of carry and subsequently influence trading strategies in derivatives markets.
  • Fluctuations in interest rates directly impact the cost of carry since higher rates increase borrowing costs for traders who need to finance their holdings. As carrying costs rise due to increased interest payments, traders may reassess their strategies regarding whether to hold physical assets or trade derivatives like futures and forwards. A rising interest rate environment could lead traders to favor immediate selling over holding positions, thus affecting market liquidity and pricing dynamics.
• Evaluate the role of cost of carry in arbitrage opportunities within commodity markets, considering its effects on pricing discrepancies.
  • Cost of carry plays a crucial role in creating arbitrage opportunities within commodity markets. When there are pricing discrepancies between spot prices and future prices due to varying costs of carry across different markets, traders can exploit these differences through simultaneous buying and selling. A thorough understanding of carrying costs allows arbitrageurs to determine whether holding an asset until maturity is profitable compared to immediate sale. This evaluation leads to price corrections across markets as arbitrage activity balances out discrepancies.

Related terms

Forward Price: The agreed-upon price for a transaction that will occur at a future date, often calculated based on the spot price adjusted for the cost of carry.

Interest Rate: The amount charged by lenders to borrowers for the use of assets, which can influence the cost of financing an asset held for trading purposes.

Arbitrage: The simultaneous purchase and sale of an asset in different markets to profit from price discrepancies, which can be affected by varying costs of carry.