What is the Cost of Carry? Meaning, Calculation, and Importance

Cost of Carry is the funds required to hold a position. The futures price of an asset is often more than its spot price or the cash price. For the seller, the price of the futures often includes the cost of purchasing, financing, storage, and insurance of the asset or commodity. Let's take a closer look at what the cost of carry is and how it works. This detailed blog explains the cost of carry definition along with its calculation.

Key Highlights

• Cost of carry (CoC) is the cost of holding the underlying assets of futures.

• Carrying costs affect the pricing of contracts in the derivative markets.

• A decline in CoC indicates a decrease in the value of underlying assets. Conversely, increasing CoC suggests traders expect a rise in asset price.

How Does Cost Of Carry Impact Financial Investments?

The cost of carry has a big role in the determination of future prices. This is because it represents the expenses that are involved in holding the asset until the contract expires. These are inclusive of interest, storage, insurance or financing charges minus income earned.

When it comes to real-world investing, a higher cost of carry brings future prices above spot prices, while a lower or negative cost of carry narrows the gaps. By understanding this concept, investors can predict future premiums, locate arbitrage opportunities, and make informed hedging and trading decisions.

Cost of Carry Meaning

Cost of carry (CoC) is the overall cost investors pay to hold their position in the underlying market until the futures contract expires. To put it another way, CoC is the difference between an index or stock's spot price and futures price.

CoC includes a risk-free interest rate. It does not apply to underlying dividends. The cost of carry is a significant factor since a higher CoC value indicates traders are ready to pay to keep futures.

Interpreting the Cost of Carry

Open interest and change in CoC provide a clear view of the sentiment regarding an asset. The total number of open positions in a contract is the open interest (OI). When the OI rises, a rise in the CoC shows the accumulation of long or bullish positions. A corresponding decline in the CoC shows the accumulation of short or bearish positions.

Similarly, a decrease in OI combined with an increase in CoC denotes the exit of short positions. A declining OI and CoC suggest that traders are exiting their long positions. Analysts also note changes in the CoC when a derivatives contract expires. Many holdings rolling over with a greater cost of carry indicates bullishness.

The following table summarises how CoC and open interest help understand the market conditions.

Calculating Cost of Carry

The cost of carry is the difference between futures and spot prices at any moment. CoC is usually expressed as an annual rate in the percentage values. So, the formula for the cost of carry is as follows.

Cost of Carry = (Futures Price - Spot Price) / (Spot Price * Time)

Let's consider the following scenario:

1. Spot Price: Rs.100
2. Futures Price: Rs.105
3. Time to Expiry: 1 year
4. Dividend Payout: Rs.2 per share annually

Using the formula for CoC:

CoC = (Futures Price - Spot Price) / Spot Price* Time: = (Rs.105 - Rs.100) / Rs.100*1 = Rs.5 / Rs.100 = 0.05

Therefore, in this case, the Cost of Carry is 0.05 or 5%. This indicates that the futures price is Rs.5 higher than the spot price.

Importance of Cost of Carry

Traders generally use the CoC to understand the prevailing market sentiment. A notable decline in CoC suggests a decline in the value of the underlying asset. For instance, once the CoC of the benchmark index Nifty futures fell almost 50%. This suggested that the price of the index would fall in the coming days.

Contrarily, an increase in CoC for a stock future indicates that traders are prepared to pay more to hold the position. It shows that they anticipate an increase in the underlying asset price. Hence, knowing the cost of carry is quite important in the futures market.

Calculating Net Returns With Carrying Costs

While evaluating the profitability of an investment, it is not reliable to focus only on price appreciation. This is because Carrying Costs (also known as the cost of carry) can affect the actual net returns on investment by adding expenses that reduce the overall profit.

• Margin

By using margins, investors can amplify returns, but it comes with costs. Brokers charge interest on borrowed funds, which continues to accrue as long as the position is open. Despite an increase in asset prices, high-margin interest can significantly eat into profits, which makes accurate return calculation essential.

• Short selling

Under short selling, you borrow shares and sell them with the objective of buying them at a lower price. The carrying cost here includes stock borrowing fees and any dividends that are paid by the short seller to the lender. With the passage of time, these costs can increase, which directly reduces returns.

• Other borrowing

When you make any kind of investments with borrowed funds, then interest payments can be considered as one type of carrying costs that lowers the total returns. These borrowing costs shall be subtracted from gains to bring the true return on investment.

• Trading commissions

Brokerage fees, exchange charges, and taxes can seem small individually. But frequent trading makes them substantial. These transactional carrying costs will lower net returns and hence should always be included in profit calculations.

• Storage

Certain physical assets, like commodities, include storage, insurance, and handling costs. These ongoing expenses increase the cost of carry, which can reduce profitability, especially for long-term holdings.

Which Markets Are Impacted By Cost Of Carry?

The cost of carry model can impact various financial markets where holding an asset over time involves costs or income. In equity markets, it reflects financing costs and dividend payouts. In commodity markets, storage, insurance, and transportation costs are key drivers. In derivatives, especially futures and forwards, cost of carry is central to pricing and arbitrage decisions. Currency markets are too impacted as interest rate differentials between two currencies effectively represent the cost of carry, which shapes the forward exchange rates and trading strategies.

Conclusion

Investors should always consider the trading costs while investing in any asset. The cost of carry of a security or commodity is one such cost that can influence an investor's choice of investment. Investors can also use it to compare the trading costs of different assets, including futures and commodities. Investors should take into account these carrying costs when determining their overall returns. Understanding the additional expenses associated with an investment instrument is essential to make the right decisions.