The Cost of Carry Definition and Formula with Examples
The cost of carry definition, or carrying charge, is the cost of holding a position. It impacts profitability, and market participants must understand the cost of carry model, as the net cost of carry increases daily. We will explain the cost of carry definition to help you understand this vital component of financial markets.
What is Cost of Carry?
The cost of carry in futures and leveraged overnight positions account for the bulk of market-wide carrying charge and interest rate expense cases. It impacts the profitability, as the carrying charge increases with duration, increasing the break-even point of each transaction in most cases. It can lower it for select financial instruments, where holders are paid a daily fee for holding an asset, usually in trades involving interest rate differentials in the Forex market.
What Factors Can Influence the Carrying Charges Definition?
It depends on the asset. Market participants must know which ones apply to calculate their daily fees or income.
Here are some cost of carry items to consider:
- Interest on long and short positions, known as swap rates in the Forex market
- Storage costs for physical goods
- Insurance fees
- The difference between the yield on a cash asset and the cost of funds necessary to buy the asset
- The risk-free interest rate
- The convenience yield
- The opportunity cost
- Dividends
What is the Cost of Carry Formula?
The simplified cost of carry formula is F = S + c, where F represents the forward price, S the spot price, and c the cost of carry. Another way to look at it is c = F - S. It may sound a bit confusing, but the below cost of carry example should clarify it.
Cost of Carry Example 1
- Buying $2,000 worth of stocks with leverage will face an overnight charge, and we will use $0.40 per day in this example, closing the trade six months later at $2,700
- You would only pay $200 for the transaction at 1:10 leverage, borrowing the rest from your broker, and face total swap rates of $72 (30 days x 6 months x $0.40 daily)
- The profit equals $700 - $72 - brokerage commissions
- While you made less profit, you freed up $1,800 for other trades, earning potentially more and diversifying your portfolio, lowering your overall risk profile
Cost of Carry Example 2
- Assume you purchase physical oil at $110 per barrel
- Monthly storage costs are $5.50, storage fees are $1.25, and insurance charges are $0.75
- Selling the barrel of oil at $120 after five months would result in a net loss of $27.50, regardless of the increase in the price per barrel, as your carrying charge is $37.50 ( x 5)
- The example shows how the cost of carry can turn a gross profit into a net loss
The more complex cost of carry formula is:
F = Se ^ ((r + s - c) x t)
- F is the forward price,
- S is the spot price,
- e is the base of the natural logarithms,
- r is the risk-free interest rate,
- s is the storage cost,
- c is the convenience yield, and
- t is the time to delivery of the forward contract (expressed as a fraction of 1 year)
In Which Markets Does the Cost of Carry Apply?
Cost of carry in futures and Forex markets, plus any leveraged trading product, mostly derivatives, face carrying charges.
How Does the Cost of Carry Impact Profitability?
The cost of carry usually applies daily, making trades more expensive with duration. It can also turn a gross profit into a net loss.
Cost of Carry Conclusion
Market participants must know the cost of carry per transaction to determine all applicable fees, gauge their strategy, compare their risk/reward ratio to other assets, and ensure they operate with a net profit.
FAQs
Who pays the cost of carry?
The trader or investors pays the cost of carry.
What are the components of cost of carry?
It depends on the asset, but they usually include capital costs, financing costs, storage costs, transportation costs, and insurance costs, where applicable.