Introduction
Cost of carry comprises the expense incurred for storing a physical product or holding a financial instrument. Some examples of carrying costs for physical items include local short rates, interest on long holdings, insurance and storage charges.
What is the cost of carry?
Cost of carry simply means the net cost of retaining a position. It is also described as the difference between a particular asset’s cost and the returns it generates over a specified period. In the commodity market, the term is used to define the additional funds paid to hold a physical asset, including insurance expenses.
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The cost of carrying for derivatives consists of the interest expenses on margin accounts. These expenses are the direct costs to pay on an underlying index or security until the futures contract expires.
Example:
If you buy scrip X at a spot price of Rs. 1,500 at an interest rate of 5 per cent per annum, you will pay a futures price of Rs. 1506.16 for one month. The additional Rs. 6.16, here, is the cost of carrying.
Which markets does the cost of carry impact?
The forex and commodities market is affected the most by the cost of carry. But there is also an impact on futures and derivatives. The cost of carry acquired by each of these markets differs. For instance, transactions in the forex market are exposed to fees in interest rate changes and overnight funding fees.
The cost of carry charges in the commodity market will be associated with transport, storage, and insurance of a physical item, provided traders acquire possession of the commodities they have a position on. In derivatives, a contract for differences (CFD) gives rise to a cost of carrying as overnight funding charges.
How to calculate the cost of carry?
In theory, the formula for calculating the cost of carry is as follows:
Future price = Spot price + Cost of Carry - Dividend payout
In other words, you subtract the spot price from the futures price.
The calculation of the cost of carry is done at an annual rate and expressed in percentage. You can view real-time cost of carry values on stock exchange websites.
The calculation formula is:
F = Se ^ ((r + s - c) x t),
where these terms refer to the following:
- F = the commodity’s price in the future
- S = the spot price of the commodity
- e = the natural log base
- r = risk-free rate of interest
- s = storage cost reflected as a spot price per cent
- c = convenience yield
- t = it is the time until contract delivery, expressed in fractions of a year
Your willingness to buy at different price levels in future markets will be influenced by your carrying costs. Convenience yield is also taken into account while calculating futures market prices. It is a valuable benefit of retaining the commodity.
Can the cost of carry be negative?
It is possible for the cost of carry to be negative. When a futures contract trades at a discount to the underlying, the cost of carrying is negative. Generally, there are two reasons for a negative cost of carry. The first is when a dividend is expected from the stock. The second is when traders actively execute a “reverse arbitrage” strategy, which encompasses buying spots and selling futures. The market sentiment is bearish when the cost of carry is negative.
How does the cost of carry affect net return?
As an investment, the cost of carry has immense potential to impact your net return or net profit. Thus, you must know all cost of carry charges that you may have to pay while trading as it affects the net profit on your trades or investments.
Conclusion
The cost of carry can become an essential element in different financial markets. It has the potential to affect your net profit. Knowing how much you may have to pay for a particular type of investment and how it differentiates from other investments can impact your investment decisions. For instance, the cost of carrying physical commodities is higher compared to other financial assets like stocks.
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