Cost-of-Carry: Definition, Carry Model & Example
Cost-of-carry simply refers to the cost incurred by an investor for holding or retaining an asset or a financial position in the market. For instance, insurance and storage charges associated with holding a physical asset.
Let's say a trader’s asses that the price of wheat will go up in the coming weeks. In order to benefit from this, he purchases 100 kilos of wheat. He will need to store and preserve this lot before he can sell it. All the associated charges like transportation, handling, storage, etc. will become the “cost-of-carry” for the trader.
In the equity market, “cost-of-carry” is used to price the Futures contracts of all underlying. As you know, Futures contracts are leveraged contracts. The “interest cost” of entering into such a contract is priced in the contract and is paid upfront.
Futures Cost of Carry Model
This model is used to understand how the cost of carrying is calculated in Futures contracts. This model works on two assumptions:
- The Futures contracts are held till maturity and not squared off before expiry.
- The arbitrage spread between the spot and Futures prices effectively eliminates all pricing flaws. Thus ensuring that the cost of carrying in futures refers to the difference between the futures and spot price.
Cost of carrying = Futures price - Spot price
However, with regards to the Futures market, the cost of carrying is considered to be a part of an underlying asset's future cost computation.
Formula: F =Se[(rf+s-c) x t]
F: future price of the underlying
S: spot price of the underlying
e: natural log base (approximated as 2.718)
rf: risk free rate
s: storage cost
t: duration till expiry (expressed as a fraction of a year)
c: convenience yield
A convenience yield refers to the perk associated with holding an underlying or physical asset, rather than the associated derivative.
This model demonstrates the relationship between various factors that influence the future price of an underlying.
How can the cost of carrying be interpreted in the market?
Cost of carrying along with open interest helps to build a clear picture for gauging the market sentiment.
|Cost of carrying||Open Interest||Indicator||Action|
|Decreases||Decreases||Cautiously bearish||Long unwinding|
|Increases||Decreases||Cautiously bullish||Short covering|
- When the cost of carrying and open interest both increase. This is a bullish indicator. Here the inference is that new long positions are being made in the market. This is referred to as a Long build-up.
- When the cost of carrying and open interest both decrease. This is a cautiously bearish indicator. The inference here is that the earlier made positions are being squared off. This is referred to as a Long Unwinding.
- When the cost of carrying decreases and the open interest increases.This is a bearish indicator. The inference here is that new positions are being made as the traders are short-selling in the market. This is referred to as a Short build-up.
- When the cost of carrying increases and the open interest decreases. This is a cautiously bullish indicator.Here the inference is that the earlier taken short positions are now being covered. This is referred to as a Short Covering.