- Cost of carry
The cost of carry is the cost of "carrying" or holding a position. If long, the cost of carry is the cost of interest paid on a margin account. Conversely, if short, the cost of carry is the cost of paying dividends, or rather the opportunity cost; the cost of purchasing a particular security rather than an alternative. For most investments, the cost of carry generally refers to the risk-free interest rate that could be earned by investing currency in a theoretically safe investment vehicle such as a money market account minus any future cash-flows that are expected from holding an equivalent instrument with the same risk (generally expressed in percentage terms and called the convenience yield). Storage costs (generally expressed as a percentage of the spot price) should be added to the cost of carry for physical commodities such as corn, wheat, or gold.
- F is the forward price,
- S is the spot price,
- e is the base of the natural logarithms,
- r is the risk-free interest rate,
- s is the storage cost,
- c is the convenience yield, and
- t is the time to delivery of the forward contract (expressed as a fraction of 1 year).
The same model in currency markets is known as interest rate parity.
For example, a US investor buying a Standard and Poor's 500 e-mini futures contract on the Chicago Mercantile Exchange could expect the cost of carry to be the prevailing risk-free interest rate (around 5% as of November, 2007) minus the expected dividends that one could earn from buying each of the stocks in the S&P 500 and receiving any dividends that they might pay, since the e-mini futures contract is a proxy for the underlying stocks in the S&P 500. Since the contract is a futures contract and settles at some forward date, the actual values of the dividends may not yet be known so the cost of carry must be estimated.
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