Learn more about how cost of carry works and the different types.
Definition and Examples of Cost of Carry
“Cost of carry” refers to the expenses that come with storing a physical commodity or holding an investment position. They may include what the investor pays for transportation costs, insurance, and interest on margin accounts, among others.
Alternate name: Carrying charges
Physical commodities are common examples of investment opportunities with several costs of carry. Physical commodities can include wheat, coffee, and precious metals, such as gold. Let’s say you purchased a significant amount of gold and sold it at a profit one year later. However, you paid additional fees for transporting, insuring, and storing the gold. Collectively, the fees totaled $100. All those fees are considered the cost of carry when you invested in gold.
How Does Cost of Carry Work?
Cost of carry has different implications for physical commodities versus owning a stock. For physical commodities, cost of carry can include the price of purchasing and transporting the goods. Investors may also need to pay to store the commodities until their prices rise to a profitable margin—something that typically does not apply when purchasing a stock. Consider this example: If you bought a stock without margin at $50 and sold it for $70 after one year, your profit would be $20 minus commissions. Now, let’s say you purchased a barrel of oil for $50. You paid for it to be transported to a storage facility and it cost you 50 cents per month to store it ($6 per year); all of those costs are your cost of carry. After one year, you sold it for $70. Your profit would be $70 minus your purchase price ($50), commissions, and the costs for transporting and storing it. Beyond transportation and storage fees, the cost of carry is sometimes computed as an opportunity cost—the risks involved in choosing one investment over another. A specific example of this is the risk-free interest rate earned when choosing a safe investment such as Treasury securities (T-securities). However, this money can be invested in riskier securities that could potentially yield higher returns. Conversely, you may lose big on risky investments. At least with T-securities, you are virtually guaranteed to make your principal back.
Cash and Carry Arbitrage
Cost of carry may prove to be the difference between a profitable and non-profitable investment decision. The cost of carry pricing relation indicates that the price of a futures contract is equal to the spot price (the price when purchasing the commodity) plus the costs of carry. In simple terms, the formula would look like: F = S + c
F = Futures priceS = Spot pricec = Cost of carry
However, when the futures price exceeds the current spot price plus the cost of carry, it presents an arbitrage opportunity. Some traders capitalize on these price discrepancies to earn seemingly risk-free profits. Cash and carry arbitrage typically occurs when a trader buys (goes long on) a commodity or stock while also taking a short position in a futures contract for the same commodity or stock. By shorting the futures contract, the trader is committing to selling the underlying commodity at a future date for a specified price. Now, if at the time of settling the futures contract, the purchase price of the underlying commodity plus its carrying cost is less than the futures price, the trader makes a profit. For example, let’s say oil trades at $100 in the market and the cost of carry is $5. Now consider there’s a futures contract for oil priced at $165. If a trader both purchases oil at $100 and shorts the futures contract at $165. By the end of the futures contract, the trader’s total cost is $105 (cost of carry included). Since the trader locked in the price at $165, the trader made a profit of $60.
What Cost of Carry Means for Individual Investors
For most investors, cost of carry could play a role in the investment decision, both from the point of view of how much they would pay for a commodity or security, as well as how such an investment compares to another. For physical commodities, cost of carry is perhaps more noticeable compared to other financial assets such as stocks.
