Futures contracts are agreements to buy or sell an asset at a predetermined price and date. They are widely used by investors, farmers, and businesses to hedge risks or speculate on price movements. For example, a farmer might use futures to lock in a price for their crop months before harvest, while a trader might bet on oil prices rising.
Understanding how futures prices are determined is critical. Unlike stocks, futures prices aren’t just about supply and demand—they also factor in costs tied to holding the underlying asset until the contract expires. This is where the concept of cost-of-carry comes into play.
Understanding Cost-of-Carry
Cost-of-carry refers to the total expenses incurred for holding an asset until a futures contract expires. Imagine you agree to deliver 100 barrels of oil in six months. To fulfill this contract, you’d need to store the oil, insure it, and possibly borrow money to buy it upfront. These combined costs shape the futures price.
In simple terms:
Futures Price = Spot Price + Cost-of-Carry
If the spot price of oil is 80 per barrel today,and holding it for six months costs 5 per barrel, the futures price would be $85. This ensures the seller isn’t at a disadvantage for committing to a future delivery.
Key Components of Cost-of-Carry
Cost-of-carry isn’t a single expense—it’s a mix of several factors:
Storage Costs
Physical commodities like oil, wheat, or gold require storage in warehouses or tanks. These fees vary. For example, storing gold in a secure vault might cost 0.5% of its value annually, while perishable goods like orange juice could have higher costs due to refrigeration.
Financing Costs (Interest Rates)
If you borrow money to buy the asset, interest payments add up. Suppose you take a 10,000 loan at 5250 in interest, which gets factored into the futures price.
Insurance
Protecting assets against damage or theft adds to the cost. A warehouse storing copper might spend thousands on insurance annually.
Income from the Asset (Dividends or Yield)
Some assets generate income. For example, holding stocks pays dividends, and owning bonds earns interest. This income reduces the net cost-of-carry. If a stock pays a 2 divid end during the contract period,the futures price would drop by 2 to account for this benefit.
Convenience Yield
This is the intangible benefit of physically holding an asset. During a supply shortage, having oil on hand might be more valuable than a futures contract, lowering the effective cost-of-carry.
The Cost-of-Carry Model and Futures Pricing
The relationship between spot prices, futures prices, and cost-of-carry is summed up in this formula:
Futures Price = Spot Price × (1 + Cost-of-Carry Rate × Time)
Let’s break this down with an example:
Gold’s Spot Price: $2,000 per ounce
Storage/Insurance Costs: $20 per year
Interest Rate: 4% annually
Time: 6 months (0.5 years)
First, calculate the total cost:
Storage/Insurance for 6 months: $10
Interest on 2,000 for 6 months: 2,000 × 4% × 0.5 = $40
Total Cost-of-Carry:10+40 = $50
Futures Price =2,000+50 = $2,050
If the actual futures price is higher than $2,050, traders could profit by buying gold now and selling futures—a strategy called cash-and-carry arbitrage. This pushes prices back to fair value.
Contango and Backwardation: Market Implications
Cost-of-carry explains two key market conditions:
Contango: When Futures Prices > Spot Prices
This happens when holding costs are high. For example, crude oil futures might trade at 85 versusa 80 spot price due to steep storage fees. Contango is common in markets with surplus supply.
Backwardation: When Futures Prices < Spot Prices
Here, futures trade below spot prices. This occurs if the convenience yield outweighs holding costs. During a wheat shortage, holding physical wheat becomes valuable, so futures prices might drop below spot prices.
Trading Strategies Involving Cost-of-Carry
Traders use cost-of-carry to identify opportunities:
Cash-and-Carry Arbitrage
If futures are overpriced, buy the asset, pay the carry costs, and sell the futures contract. At expiration, deliver the asset for a risk-free profit.
Reverse Cash-and-Carry Arbitrage
If futures are underpriced, short-sell the asset, invest the proceeds, and buy futures. This works best for financial assets like stocks.
Roll Yield Strategies
In backwardation, holding long futures positions can generate “roll yield” as contracts gain value nearing expiration.
Real-World Examples of Cost-of-Carry in Action
Example 1: Gold Futures
Gold’s futures price often includes storage and financing. If interest rates rise, futures prices increase because financing gold purchases becomes costlier.
Example 2: Equity Index Futures
For the S&P 500, dividends reduce the cost-of-carry. If the index pays a 2% dividend annually, futures prices will be lower than the spot price by that amount.
Example 3: Agricultural Commodities
Corn futures might swing into backwardation if a drought threatens supply, making immediate ownership more valuable than future delivery.
Conclusion
Cost-of-carry is the backbone of futures pricing. By accounting for storage, financing, and income, it ensures fairness between buyers and sellers. Whether you’re hedging or speculating, grasping this concept helps decode market trends like contango and craft strategies like arbitrage.
In a world where a 1% difference in costs can make or break profits, mastering cost-of-carry isn’t just academic—it’s essential for smart trading.
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