Derivatives
Understanding Cost of Carry
When pricing forwards and futures, the biggest mistake students make is jumping straight to formulas. Cost of carry is not a formula first. It is a way of thinking. It answers a simple question: what does it cost, or benefit, to hold an asset over time?
Once this logic is clear, futures pricing stops feeling mechanical and starts making sense.
What Cost of Carry Really Means
Cost of carry represents the net cost or benefit of holding an asset until a future date.
It includes everything that affects the value of holding the asset:
- financing costs
- storage or holding costs
- income earned from the asset
If holding the asset is expensive, the cost of carry is positive.
If holding the asset generates income, the cost of carry can be negative.
Why Cost of Carry Matters
The cost of carry links today’s spot price to the future price.
Futures and forward prices are set so that no arbitrage opportunity exists. To achieve this, the market adjusts the future price to reflect what it costs (or pays) to carry the asset forward in time.
This idea appears repeatedly in derivatives exams because it connects pricing, interest rates, and arbitrage.
Components of Cost of Carry
The cost of carry depends on the type of underlying asset.
Financing cost
This is usually the interest cost of borrowing money to buy the asset. It is often the most important component.
Storage and holding costs
These apply mainly to physical commodities. Warehousing, insurance, and transportation all add to the cost of carry.
Income from the asset
Dividends, coupons, or yields reduce the cost of carry because the holder earns cash while holding the asset.
The net effect of these components determines the final cost of carry.
Positive and Negative Cost of Carry
A positive cost of carry means it costs money to hold the asset. This pushes the future price above the spot price.
A negative cost of carry means holding the asset provides income that exceeds holding costs. This pulls the future price below the spot price.
Understanding this direction is more important than memorising equations.
Cost of Carry Across Different Assets
For non-dividend-paying stocks, the cost of carry is mainly the financing cost.
For dividend-paying stocks, expected dividends reduce the cost of carry.
For bonds, coupon payments reduce the cost of carry, while financing costs increase it.
For commodities, storage costs increase the cost of carry, while convenience yield may reduce it.
Exams often test whether candidates apply the correct components to each asset class.
Cost of Carry and No-Arbitrage Pricing
The future price is set so that buying the asset today and carrying it forward produces the same outcome as entering a forward or futures contract.
If the future price is too high, arbitrageurs buy the asset and sell the future.
If the future price is too low, arbitrageurs sell the asset and buy the future.
Cost of carry ensures this balance holds.
Common Exam Confusions
Students often forget to subtract income from the asset.
Another mistake is applying storage costs to financial assets that do not require storage.
Some candidates confuse cost of carry with expected return. They are not the same.
These errors are usually tested conceptually rather than numerically.
Final Thought
Cost of carry is the bridge between spot prices and future prices. It captures the real-world costs and benefits of holding an asset over time and ensures fair pricing through arbitrage. For exam preparation, focus on understanding what adds to the cost of carry, what reduces it, and how it affects futures prices. Once this intuition is clear, pricing questions become far easier to handle.
