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Trading in the Indian financial market comes with many factors that must be thoroughly understood to engage in profitable trades. One feature that is important to understand is the cost of carry (CoC). It refers to the cost of holding a position. The term defines the difference between an asset’s cost and its return over time. In this article, we will look at the cost of carry in detail along with its calculation.
What is the cost of carry?
In simple terms, the cost of carry refers to the net cost of holding a position. Capital markets utilize this measure to determine the difference between the cost of an asset and its return over time. It is an integral component of determining the cost of the futures contract.
Additionally, it also determines the difference between the yield generated on cash assets and the total cost of financing the asset. You can simply understand the cost of carry as the futures price minus the spot price.
In the commodity market, the cost of carry equals the physical cost of holding an asset including its insurance payments. In the derivatives market, the CoC is inclusive of interest expenses on margin accounts which are the charges incurred on the underlying security and indexes till the futures contract expires.
It also accounts for interest on loans used to make an investment, interest costs on bonds and the opportunity cost of taking one position over another.
The cost of carry might be ambiguous across markets, impacts the trading demand and might even create arbitrage opportunities.
Futures cost of carry model
The cost of carry futures is an integral component of the futures and forward contract calculation in the derivatives market. The cost of carrying might differ for traders and investors and might affect their decision to buy at different price levels in the futures market.
Additionally, convenience yield which refers to the valuable benefit of holding a commodity also influences the futures market price. The cost of carry formula is:
F = Se ^ ((r + s – c) x t)
Where:
● F = the price of the commodity in the future
● S = the commodity’s spot price
● e = natural log base, approximation 2.7181
● r = rate of interest that is risk-free
● s = storage cost (calculated as a fraction of the spot price)
● c = the convenience yield
● t = the time to deliver the contract, expressed in fractions of a year
This formula can be used to understand the different factors affecting a price in the future and the relationship between them.
Different markets use different models to calculate their derivative prices. However, any derivative pricing model involving a future price for an underlying asset is bound to incorporate some cost of carry factors if they exist.
In the options market for stocks, the Binomial Option Pricing Model helps identify values associated with option prices for American options and the Black-Scholes Option Pricing Model does the same for European options.
Cost of carry and its impact on net return
The cost of carry calculations impacts the net returns in different markets. Investors must take into account the carrying cost of investment when calculating their net returns.
Many of these expenses are the same as expenses considered as foregone in the derivative market pricing considerations. The different cost of carry factors that investors must account for include:
- Margin: Using a margin requires interest payments since it is equivalent to borrowing. As a result, the interest costs must be subtracted from the total return amount.
- Short selling: Investors should account for foregone dividends as an opportunity cost in short selling.
- Other borrowing: In investments made with borrowed funds, the interest payment on loans is a carrying cost to be subtracted from the returns.
- Trading commissions: Additionally, trading costs accrued while entering or exiting a position also reduce the total returns.
- Storage: In markets that require physically storing assets, the cost of carrying further increases. For all physical commodities, the obsolescence, storage and insurance impact must be calculated.
Conclusion
The cost of carrying a commodity or security can significantly impact their investing or trading decision. It alters how much an investor is willing to pay for an investment and how it compares with other investment opportunities.
Physical commodities have a higher cost of carrying compared with assets such as stocks. As a result, it is crucial for you to thoroughly understand the concept of cost of carry to calculate net returns on investments and make informed decisions. To learn more, subscribe to StockGro!
FAQs
Yes, cost of carry refers to the cost incurred for holding a position and lowers the net returns received on an investment.
The components of the cost of carry include interest on loans, insurance payments, and opportunity costs.
The cost of carrying physical commodities is higher than assets like stock because of physical storage and insurance requirements.
Factors to consider in net return calculations include margin, short selling, other borrowing, trading commissions and storage.
The cost of carry formula is F = Se ^ ((r + s – c) x t), where F = the price of the commodity in the future, S = the commodity’s spot price, e = natural log base, r = rate of interest that is risk-free, s = storage cost, c = the convenience yield, and t = the time to deliver the contract.
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