Cost of Carry Definition - Stock Traders Glossary

The cost of carry is the total expense incurred for holding a financial asset or physical commodity over a specific period. This concept is crucial in various financial markets, including futures, options, and commodities trading. The cost of carry includes several components: storage costs, insurance costs, and financing costs, which are often offset by any income or yield generated by the asset during the holding period. For example, in the context of commodities like wheat or oil, the cost of carry would include storage fees, insurance premiums to protect against loss or damage, and interest expenses if the purchase was financed through borrowing.

In financial markets, particularly in futures and options trading, the cost of carry plays a significant role in pricing and arbitrage opportunities. For instance, if an investor buys a stock and simultaneously sells a futures contract on that stock, the cost of carry will influence the pricing of the futures contract. The price difference between the spot price (current market price) of the stock and the futures price (agreed-upon price for future delivery) should ideally reflect the cost of carrying the stock until the futures contract's expiration. This ensures there is no arbitrage opportunity where traders could earn a risk-free profit.

An example can be seen in the gold market. Suppose an investor buys gold at the current spot price and incurs costs for storing it in a secure facility, insuring it, and refinancing the purchase with borrowed funds. If these costs total $50 per ouunce over a year and the investor can earn $10 per ounce by lending the gold, the net cost of carry would be $40 per ounce. This net cost is crucial for determining the fair price of gold futures contracts.

Understanding the cost of carry is essential for traders and investors as it helps in making informed decisions regarding the pricing of derivatives, the timing of purchases and sales, and the evaluation of arbitrage opportunities.