Definition
Cost of Carry is a finance term referred to the costs associated with holding a financial position or investment over a certain period of time. It can include various expenses such as interest on borrowed funds, storage fees, insurance costs, or any dividends or interest missed out on from investing elsewhere. These costs can in turn influence decisions about whether to hold or sell the investment.
Key Takeaways
- Cost of Carry refers to the costs incurred as a result of an investment position. These costs can include financial costs such as interest payments on the capital used to finance the position, as well as economic costs such as the opportunity cost of taking up the position.
- It is used primarily in the futures markets to determine the price of a futures contract. It represents the interest that would be earned on money used to buy an asset right away, less any income earned on the asset during the period of the investment.
- A positive cost of carry indicates that holding an asset is expensive, and as a result, the future price of the asset would be expected to be higher than the spot price. A negative cost of carry suggests that holding the asset provides a return, and the future price is expected to be less than the spot price.
Importance
The finance term “Cost of Carry” is crucial because it refers to the cost involved in holding an investment or security over a specific period.
These costs can include financial charges such as interest payments on a loan used to acquire the investment, storage costs, insurance fees, and foregone interest that could have been earned from an alternative investment.
Understanding the “Cost of Carry” is critical for investors as it can significantly impact the total returns on an investment.
Thus, an accurately calculated cost can help investors make informed decisions, as they can compare the costs against the anticipated return on investment, determine the investment’s feasibility, and evaluate if the returns justify the total expenses.
Explanation
The purpose of the concept of Cost of Carry is predominantly to evaluate the value or price of a security or commodity in the financial and investment markets. Essentially, it is a tool that helps in determining the cost incurred for holding a financial investment over a specific period of time.
The Cost of Carry includes all the costs which investors are required to bear for holding an investment position or asset—this could be interest expenses, storage costs for physical commodities, foregone interests or opportunity costs, and even income generated from the investment, like dividends or interest. In derivatives markets, this concept plays a paramount role in pricing futures contracts.
An accurate cost of carry significantly enables the arbitrage pricing mechanism, where the futures price can be linked to the spot price and associated carrying costs. Investors or traders can anticipate if the markets offer profitable opportunities by comparing the future price predicted using the cost of carry model and the actual future price in the market.
If there are discrepancies, opportunities for arbitrage, where traders can buy and sell simultaneously to profit from the price differences, may exist.
Examples of Cost of Carry
Real Estate Investment: Consider a person who buys a real estate property with the intent of renting it out. The Cost of Carry here would include all the expenses like mortgage payments, property taxes, insurance, maintenance costs, etc., that the owner incurs while holding onto the property before it generates any income. If the rental income generated is less than these costs, then the investor is effectively bearing a cost to carry this investment.
Commodity Market: In the context of commodity markets, an example of Cost of Carry can be seen in the case of storing physical commodities such as gold or oil. These stored commodities do not generate any returns while in storage, but rather incurs costs such as storage charges, insurance, and financing fees. These costs represent the Cost of Carry and affect the commodity’s futures price.
Stock Investment: Consider an individual who borrows money to purchase shares of a large corporation. The Cost of Carry in this scenario would include the interest payment on the borrowed money and any dividends that have to be paid out. The investor must consider this cost against any potential profits they expect to make from the appreciation in the stock price. If the total cost of carry exceeds the profits, the investment is in negative carry; otherwise it’s a positive carry.
Frequently Asked Questions about Cost of Carry
What is Cost of Carry?
The Cost of Carry is a model that represents the costs incurred as a result of keeping (carrying) an investment, which can include financial costs such as interest, storage costs, insurance costs etc.
How does Cost of Carry work?
It is the potential interest earned if the money used for buying an asset was invested elsewhere, minus any income from the asset plus the costs of storing the asset.
Is there a formula for Cost of Carry?
The basic cost of carry formula is: Cost of Carry = Interest Expenses – Income + Storage Cost. However, different markets may have specific adjustments to this basic formula based on their peculiarities.
What is the importance of Cost of Carry?
Understanding cost of carry is crucial for investors because it allows them to compare the costs of carrying a position with the potential profits. It also permits them to calculate the most efficient way to take a position: through the spot market or the futures market.
What impact does Cost of Carry have on futures pricing?
The cost of carry has a direct impact on the pricing of futures contracts. If the costs are high, it will typically lead to a higher futures price. This concept is sometimes referenced as the ‘cost of carry model’ for futures pricing.
Related Entrepreneurship Terms
- Spot Price
- Forward Price
- Interest Rate
- Storage Costs
- Opportunity Costs
Sources for More Information
- Investopedia : An extensive resource for investing and finance-related topics. You can search “Cost of Carry” in the search bar.
- CFA Institute : A global, nonprofit member organization of financial analysts, portfolio managers, and other investment professionals. Topics related to “Cost of Carry” may be dived into more deeply here.
- The Balance : A source of personal finance and money news, tips, and reviews. Look for “Cost of Carry” or other finance-related topics in their search bar.
- Coursera : You can find online courses related to finance that may cover topics like “Cost of Carry”.
