The cost of carry is a financial concept that calculates the expenses involved with holding or carrying an asset, such as stocks, bonds, or commodities, over a given time period. It indicates the cost of financing the asset’s purchase, which includes interest, dividends or coupon payments, storage charges, and other carrying costs.
Components of Cost of Carry
- Interest Expenses: For financial assets purchased on margin or with borrowed funds, the cost of carry comprises interest payments made on the borrowed capital. This interest cost represents the opportunity cost of employing leverage to fund the asset purchase.
- Dividends or Coupon Payments: For equities stocks or bonds, the cost of carry may include dividends or coupon payments received by the investor while holding the securities. These payments help to offset some of the financing costs associated with keeping the asset.
- Storage and Insurance fees: For physical commodities or things, such as precious metals, agricultural products, or inventory items, the cost of carry includes the storage, insurance, and handling fees required to keep the asset in physical possession.
Calculating the Cost of Carry
The formula for calculating the cost of carry is as follows:
Cost of Carry = Financing Costs – Income Received + Storage Costs
Financing costs include interest and borrowing costs for purchasing an asset.
- revenue Received includes dividends, coupon payments, and other revenue derived from the asset’s ownership.
- Storage Costs are the expenses incurred in preserving and maintaining the asset’s physical possession, if any.
Importance of Cost of Carry
- Arbitrage Opportunities: Cost of carry research identifies arbitrage opportunities in financial markets by comparing the cost of carrying an asset to its future price expectations. A positive cost of carry indicates a potential profit opportunity for arbitrageurs.
- Futures Pricing: In derivatives markets, the cost of carry is critical in setting the pricing of futures contracts compared to the spot price of the underlying asset. Futures prices often reflect the cost of carry, which includes financing fees and income earned, in order to assure convergence with the spot price at expiration.
Conclusion:
Cost of carry is a fundamental concept in finance that assesses the costs involved with holding or carrying an asset over time. Calculating the cost of carry allows investors and traders to assess the profitability of investment strategies, find arbitrage possibilities, and make informed asset allocation and trading decisions.
