Cost of Carry Model: The cost of carry refers to the cost incurred when buying a forward contract or option and holding it to maturity. It is calculated as...
Cost of Carry Model:
The cost of carry refers to the cost incurred when buying a forward contract or option and holding it to maturity. It is calculated as the difference between the forward price and the current market price.
Assumptions of the Cost of Carry Model:
The underlying asset follows a simple random walk, meaning that future prices are independent and identically distributed.
The forward price is fixed at the time of the forward contract's inception.
There are no brokerage costs or transaction costs associated with the forward contract.
The underlying asset has a constant volatility.
Formula for the Cost of Carry:
Cost of Carry = Forward Price - Current Market Price
Interpretation of the Cost of Carry:
If the forward price is higher than the current market price, the cost of carry will be negative. This means that the buyer is getting a discount on the forward price.
If the forward price is lower than the current market price, the cost of carry will be positive. This means that the buyer is paying a premium for the forward price.
The cost of carry is sensitive to changes in the forward price, as any increase in the forward price will result in a corresponding decrease in the cost of carry.
Implications of the Cost of Carry Model:
The cost of carry can be used to assess the profitability of a forward contract or option trade.
It can also be used to compare the cost of carry of different forward contracts with different maturity dates.
Understanding the cost of carry can help traders manage their risk exposure and optimize their profitability.
Examples:
If a company enters into a forward contract to buy a barrel of oil at a fixed price of 0.
If the current market price of oil is 10.
If the cost of carry is negative, the buyer is getting a discount on the forward price, implying that they are paying less for the contract than its market value