What is the cost of carrying?

The cost of carrying model has based on the premise that the futures price of an asset is the spot price plus the cost of carrying. This cost of carrying is an absolute number but the cost of carrying model presents it in percentage terms. The cost of carrying in the future is an important concept and you need to understand the cost of carrying formula and the importance of the cost of carrying.

Understanding the cost of carrying Model

Let us understand the cost of carrying with a basic commodity futures contract for delivery. To work the contract, there will be the cost of transportation, insurance to prevent the loss, cost of warehousing, and demurrage charges. if any etc. All these will add up the interest cost of locking up funds for a month. All these add up as the cost of carrying for a commodity futures contract.

In the case of the cost of carrying in futures on equity, index futures, or currency futures, there are no insurance, warehousing, or transportation costs as these contracts are cash-settled. Hence, interest cost or national interest is the only factor that goes into the cost of carrying.

Importance of cost of carrying model

To understand the cost of carrying, you must get familiar with the cost of the carrying model. The model assumes that the arbitrage spread between the spot price and the futures price effectively obviates all obvious and not-so-obvious imperfections in pricing. Once all these other factors are eliminated, the only thing that justifies the gap between the spot price and the futures price is the cost of carrying. As the name suggests, it is the cost of carrying the futures position in your books. In the cost of carrying model, the assumption is that such futures contracts are held till maturity and not squared off in between.

Based on the cost of carrying model, we can summarize the relationship as under:

Futures Price = Spot Price of the asset + net cost of carrying till expiry.

The longer the expiry period, the higher will be the cost of carrying as it enhances risk.

Let us quickly summarize what goes into the cost of carrying. In short, the net cost of carrying encompasses all the costs that you may have had to incur to hold a similar position open in the cash market. These costs are adjusted by deducting any returns that you would have received from this position in the form of dividends, bonuses, etc. Here are some of the key inclusions in the cost of carrying.

• Financing charges, where you have borrowed for cash position
• Opportunity cost, where cash position is taken with own funds
• Adjustment for dividend returns
• Adjustment for bonus returns.

How do you judge dividend returns in the case of index futures? You take the index dividend yield like the Nifty or Sensex dividend yield as a proxy. The moral of the COC (cost of carrying) story is that there are costs and benefits in keeping a position open in the cash market and the futures price compensates you to reflect these costs.

What is rollover?

Can you take a 6-month view with futures? That is where rollover comes in. Each month you rollover your position to the next month. Effectively, if you are long on RIL futures, then you simultaneously sell the current month's futures and buy the next month's futures. When you roll over a long position, there is a cost and when you roll over a short position, there is an income to you. Today, the rollover window makes the entire task a lot simpler where you just define the rollover spread and the actual execution happens in a jiffy.

How are derivatives linked to the stock price?

Derivatives prices are derived from the underlying spot price and hence they move in tandem with the spot price. At times, it is also the other way round as changes in futures price increase the arbitrage gap and make futures buying more attractive, pushing up the spot price in the process