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.

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.

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.