What is the Cost of Carry Model and Why Investors Should Know About It?
Introduction:
The cost of carrying refers to the expenses incurred in owning and holding an asset. When you own an asset like stocks, land, or gold, you need to pay certain costs such as interest, storage fees, insurance, or other expenses associated with holding that asset over time. The cost of carrying is the difference between these expenses and the profits you earn from that asset. Essentially, it's the total cost of keeping the asset in your possession and the financial impact it has on your overall investment returns.
What is the Cost of carrying and Arbitrage?
The cost of carrying or carry cost is the extra amount of money you need to spend to keep or hold onto an asset or investment. It can mean different things depending on the market you are involved in. This cost has a significant impact on trading demand and can even create opportunities for making profits through arbitrage.
Arbitrage: The definition of cost of carry would be incomplete without the term arbitrage. So now let us understand the word arbitrage in very simple language. It is a strategy where you buy and sell currency or commodities at the same time in different markets. The idea behind this is to take advantage of the fact that the prices of the same assets can vary across different markets. By doing this, you can make a profit by buying at a lower price in one market and selling at a higher price in another market. It is like finding a good deal and selling it for more money elsewhere.
Which Markets Does Cost-of-Carry Impact?
After knowing the definition of cost of carry, let us now understand in which market it has a great impact. The cost of carrying refers to the additional expenses or charges associated with holding or trading certain assets in different markets. It primarily affects the foreign exchange (forex) and commodity markets. In forex trading, when you make a transaction involving different currencies, there may be additional costs in the form of interest rates or overnight funding charges. These charges are incurred for holding the currency positions overnight. In the commodity market, the cost of carry includes various physical services that traders need to pay for when they take possession of the actual commodity. This can include expenses for storage, transportation, and insurance of the asset. However, if traders are using derivatives like contracts for difference (CFDs), they will still incur a cost of carry, but it will be in the form of overnight funding fees instead. Overall, the cost of carrying refers to the additional expenses traders face when holding or trading assets, and it varies between forex and commodity markets based on the specific costs involved.
What is the cost-of-carry model?
After understanding the definition of Cost of carry, arbitrage, and its implications, let us now understand the definition of the term cost of carry model. The cost of carrying refers to the expenses associated with holding a futures contract until its maturity instead of closing it out early. It considers factors such as interest rates, storage costs, and any other costs incurred while holding the contract. The model assumes that the price difference between the spot price (the current price of the commodity) and the future price (the price agreed upon for future delivery) eliminates any pricing discrepancies. The spot price is like the face value of the commodity, while the futures price is the sum of the spot price and the cost of carry. Essentially, the cost of carry is the only variable that justifies why the spot price and the future price differ. It accounts for the expenses you would have to bear by holding the futures contract until its maturity rather than closing it before.
What is the Cost of Carry Futures?
The cost of carry in the futures market is a factor used to determine the price of a future contract. It considers various expenses associated with holding the underlying asset, such as insurance, storage fees, and the cost of financing. When calculating the cost of carrying a physical commodity, we also consider factors like inventory costs. Different investors have different strategies for evaluating the effects of the cost of carrying on their investments. As a result, it's challenging to come up with a fixed plan of action based solely on the cost of carrying commodities.
Conclusion:
So, to conclude the topic, the cost of carrying is an important factor to consider when making investments. It has a big impact on how much money investors make from a trade. If investors do not take it into account, they might think they are making more profit than they are. The cost of carry also helps investors understand the prices of futures contracts for different commodities, which can help them make better investment plans. So, investors always need to consider the cost of carrying because it can either make or break an investment.
