May 02

Cost of Carry Model - 9 min. screencast

by David Harper, CFA, FRM, CIPM

The cost of carry model is sort of a super-charged time value of money formula. If we are going to buy a commodity in the future (F0) instead of buying it today (S0), what is the sensible forward price? It is a function of the net cost to the holder of the asset (the one who "carries" the commodity). Since the futures buyer is not bearing the "cost of carry," he/she must compensate the bearer of the cost of carry. The net cost includes costs and/or benefits:

Financing rate (r): increases forward price
Storage costs (u): increases forward price
Income/dividend yield (q): decreases forward price because it is a benefit to the holder/owner of the commodity (as such, storage costs can be viewed as negative income)
Convenience yield (y): any quantifiable benefits to ownership/carry (we could conceptualize convenience yield, similarly, as negative storage costs!)

Here is the screencast: