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 What is the Cost of Carry Model and Why Investors Should Know About It

12 Jul 2023

Introduction

  • If you are an investor, you must have come across the term 'cost of carry'.
  • This term, which seems complicated, refers to the cost of carrying an asset. This could be any asset, such as stocks, or commodities like land, gold, etc.
  • We must pay a certain amount of interest to own anything, and the difference between what we pay and the profits earned from that commodity is what is referred to as the cost of carry. 

What is the Cost of Carry?

  • To put it simply, the cost of carry, or carry cost, is the additional amount that one needs to expend to hold an asset or maintain a position. 
  • Since it's quite a branching term, it has various ambiguous meanings depending on the market. 
  • It has a huge impact on trading demand and can also create arbitrage opportunities.
  • The term 'arbitrage' simply refers to the act of simultaneous buying and selling of currency or commodities in various markets.
  • This is done to take advantage of the differing prices for the same assets. 

 

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Which Markets Does Cost-of-Carry Impact?

  • The cost of carry mainly impacts two markets: forex (foreign exchange) and commodities.
  • Although other products, such as derivatives, are also impacted by it to a certain extent, the cost of carry works differently for each market. 
  • For example, in forex, any transaction might have some additional costs associated with it in the form of an interest rate or an overnight funding charge.
  • On the other hand, for the commodity market, the cost of carry charges are incurred for more physical services. This may include storage, transport, and insurance of the asset. Of course, this is the case only when the trader takes possession of the commodity that they have a position on. Derivatives such as contracts for difference (CFDs) generate a cost of carry as overnight funding fees. 

What is the Cost of Carry Model?

  • To further understand the cost of carry, we must understand its model. The model assumes that the difference in price between the spot price and the future market price eliminates any discrepancies in pricing.
  • The spot price can be considered the face value of any commodity. The futures price comprises the sum of the spot price and the cost-of-carry.
  • After we have taken into account all these prices, the cost of carry is the only variable that justifies the difference between the spot price and the future price.
  • Thus, from its name itself, we can conclude that the cost of carry is the expense one has to bear to hold a futures position.
  • Within this model, we are taking into account that the futures contracts will be retained until their maturity and not closed out in between.

What is the Cost of Carry Futures?

  • In the derivatives market for futures, the cost of carry is an element of the calculations for future prices. 
  • In simple terms, it can be used to compute a stock’s future cost. If we are calculating this cost for a physical commodity, we will also take into account insurance, storage rates, and inventory pricing. 
  • Every investor has different tactics when it comes to assessing the impacts of the cost of carry on their investments.
  • Thus, it is difficult to ascertain a strict plan of action depending on the cost of carry of commodities. 

Conclusion

  • To sum up, the cost of carry is a deciding factor when it comes to investments and plays a significant role in calculating an investor’s net profits. 
  • Investors must be aware of this margin since it affects how much they make of the trade as a whole. If not taken into account, it will inflate the results of a net profit calculation.
  • It also helps understand the futures prices for certain commodities and form plans with better information. 
  • Thus, the cost of carry is something that investors must always take into account while investing, as it can make or break an investment. 

 

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