What is Cost of Carry?

What is Cost of Carry in Derivatives?

The term “Cost of Carry model” is common in the financial market and can be defined as the costs of owning an asset or maintaining a position. It includes aspects such as storage expenses, funding expenses, and numerous other expenses associated with maintaining an asset. These costs are important to assess and analyze future and option trading opportunities.

It is one of the most important aspects of the analysis of an investment or a trade. It is relevant where the cost of holding or safeguarding assets for the benefit of the investors has to be incurred. For instance, in the commodity market, the cost of storing assets is embraced in the cost of carry.

 

Methods to Calculate the Cost of Carry Model

There are two primary methods that are used to calculate the cost of carry: “Cash and Carry” and “Synthetic Futures”. 

 

Cash and Carry

The shape of the graph portrays the relationship between the spot and the future price of the security. It enables you to determine the right cash balance to use in funding security as opposed to funding a futures contract on the same security. That is, if the former is lower than the latter, it signals an arbitrage opportunity, and investors will be able to make riskless profits.

 

Synthetic Futures

On the other hand, synthetic futures cost of carry is based on the cost of a stock index and the cost of a futures contract on the same stock index. This approach assists in identifying the fair value of the index and the futures contract.

 

Benefits of Cost of Carry

It's the idea that plays a crucial role when trading in derivatives such as futures or options, which allows the investors to hedge or make bets on price changes in the underlying instruments.

• The cost of carry helps traders determine whether a specific trading plan is moneymaking and establishes trading opportunities. 
• For instance, if the cost of carry in short selling strategy is relatively high, then it would mean that such a strategy could not be implemented or could not make profits.
• The cost of carry is also useful in the decision-making processes, such as the purchase of stocks, bonds, or any real property.
• It enables investors to modify the most comprehensive cost of owning security and make decisions concerning investment goals and capacities.

 

Conclusion

The financial market utilizes the cost of carry as an important valuation measure. This is why it is important to everyone who is involved in investing and trading in the derivatives market. It helps you get the highest return on your investment.