What is the cost of carry?

Cost of carry is the amount of money it costs to hold onto something over time. This something could be any type of asset, like gold, wheat, stocks, or really anything with value that a person or company owns. People often just call this the “carrying cost”.

When you own an asset, there are costs that come along with that. If it’s gold, you need a safe place to store it so it doesn’t get stolen. That storage costs money. If it’s a big pile of wheat, you need a big barn or silo to keep it in so it doesn’t go bad. Building that silo isn’t free. See how this works?

Why does the cost of carry matter?

The cost of carry matters because it affects how much an asset will be worth in the future. This future value is super important for planning and decision-making.

Let’s use an easy example. Say you have $100 today. But it costs you $10 to carry that $100 for one year (maybe the bank charges you a $10 fee). In a year, you won’t have $100 anymore, you’ll only have $90 because of that cost to carry the money. The future value of your $100 is only $90. Bummer!

What goes into calculating carrying costs?

To figure out the total cost of carry, we need to add up all the little costs that chip away at an asset’s value over time:

Financing costs

Often people borrow money to buy assets. The interest they pay on that borrowed money is a carrying cost. If you borrow $1000 at 6% interest to buy some gold, that 6% or $60 per year is part of your carry cost.

Insurance

Want to protect your asset? Insurance can do that, but it comes at a price. That price gets added to your carrying costs. If you pay $200 per year to insure your pile of gold bars, that’s $200 added to the cost of holding them.

Transportation

Getting your asset from point A to point B costs money too. This could be gas, freight charges, or other shipping fees. Shipping a ton of wheat halfway across the country is pricey! And it’s all part of the carrying cost.

Storage

As we talked about before, most assets need to be stored somewhere. And storage isn’t free. Fees for storing gold in a secure vault definitely add to the cost of holding onto it.

What about the benefits of owning an asset?

Great question! There are often some benefits to owning an asset that can offset the costs a bit:

Lending income

Sometimes you can lend your asset to someone else and charge them a fee. This is common with money and stocks. That rental income reduces your overall carry cost.

Convenience yield

Some assets are just really useful to own. Maybe you run a jewelry business and need a stock of gold on hand to make your products. The benefit of having that gold right there when you need it is called the “convenience yield”. It’s hard to put an exact price on, but it definitely helps cancel out some carrying costs.

Putting it all together

If we want to know an asset’s total cost of carry, we’d make a little equation:

Cost of Carry = Financing + Insurance + Transportation + Storage – Lending Income – Convenience Yield

Plug in the numbers and boom, you’ve got your carry cost. Positive number means it costs money overall to hold the asset. Negative number means the benefits outweigh the costs – you actually make money by holding it!

Why should I care about cost of carry?

The cost of carry helps us make smarter decisions and plans with our assets. A couple big reasons it matters:

Setting futures prices

A futures contract is an agreement to buy or sell an asset at a specific price on a specific future date. To figure out a fair price for that future transaction, we need to account for the cost of carry. The price should cover all those costs the seller will rack up by holding the asset until the sale date.

Spotting arbitrage opportunities

Cost of carry can also help you spot chances for arbitrage. That’s when you can make a riskless profit by simultaneously buying and selling an asset in different markets.

If wheat costs $100 per ton today, but a futures contract says you can sell it for $150 in six months, is that a good deal? Depends on the cost to carry that wheat for six months! If the carrying costs are less than $50, you could buy the wheat now, pay the carry costs, then sell the futures contract and pocket the difference as profit. That’s arbitrage powered by carry costs.

A few key things to remember

• An asset’s total cost of carry includes financing, insurance, transportation, and storage costs
• But income from lending and the convenience of ownership can reduce the carry cost
• Knowing the cost of carry helps set fair futures prices and spot arbitrage opportunities
• Whether you’re a big time trader or just an everyday investor, grasping the concept of carrying costs can help you make savvier moves with your assets

The cost of carry may seem a little complex at first, but it really boils down to a simple idea – holding onto stuff usually isn’t free! Once you learn to tally up those costs, a whole new world of asset analysis and investment strategizing opens up to you.