Definition
Cost of carry refers to the total costs associated with holding a financial asset or a physical commodity over a specific period. These costs can typically include storage expenses, insurance, financing charges, and any other related expenses necessary to maintain the asset.
Examples
- Physical Commodities: If an investor holds physical gold as an asset, the cost of carry might include storage fees paid to a secure vault, insurance premiums to protect against theft or damage, and interest costs if the gold was purchased with borrowed funds.
- Financial Instruments: When an investor buys a stock on margin (using borrowed funds), the cost of carry would include the interest charged by the brokerage on the borrowed amount.
- Real Estate: Holding an investment property involves carrying costs such as property taxes, mortgage interest, insurance, and maintenance expenses.
Frequently Asked Questions
What components make up the cost of carry?
The cost of carry can consist of storage costs, financing costs, insurance, maintenance expenses, and other fees directly associated with holding the asset over time.
How does the cost of carry affect investment decisions?
High carrying costs can reduce the net returns from holding an asset, making it less attractive compared to other investments with lower carrying costs. Investors often consider these costs when deciding whether to execute a trade or hold an asset.
Can the cost of carry be negative?
Yes, in some situations, the cost of carry can be negative. This occurs when the yield or income generated from the asset exceeds the costs associated with holding it. For example, if an asset pays high interest or dividends that cover the financing and maintenance costs, the net cost of carry can be negative.
How is the cost of carry calculated?
The cost of carry is typically calculated by adding up all the expenses related to holding the asset (such as storage fees, interest on borrowed funds, insurance, and maintenance) and subtracting any income generated from the asset during the holding period.
Is the cost of carry the same for all assets?
No, the cost of carry varies depending on the type of asset and the specific factors involved in holding it. For example, carrying costs for commodities like oil or gold will differ from those associated with financial instruments such as stocks or bonds.
Carrying Costs: Similar to cost of carry, this refers to the expenses incurred to hold or store an asset over a specific period. It is commonly used in real estate and inventory management.
Online Resources
Suggested Books
- “Fundamentals of Futures and Options Markets” by John C. Hull: This book provides a comprehensive understanding of various financial derivatives and the underlying concepts, including the cost of carry in futures markets.
- “Investment Analysis and Portfolio Management” by Frank K. Reilly and Keith C. Brown: This resource delves into the intricacies of investment analysis, including the various costs, such as the cost of carry, that impact asset holding and portfolio management.
Accounting Basics: “Cost of Carry” Fundamentals Quiz
### Which of the following expenses is NOT typically included in the cost of carry?
- [ ] Storage costs
- [ ] Insurance premiums
- [ ] Financing costs
- [x] Sales tax
> **Explanation:** Sales tax is typically charged at the time of purchase, not as a recurring cost of holding an asset. Storage, insurance, and financing are ongoing expenses associated with carrying an asset.
### What type of financial strategy assesses the cost of carry?
- [x] Carry trade
- [ ] Day trading
- [ ] Scalping
- [ ] Swing trading
> **Explanation:** Carry trade strategies assess the cost of carry by exploiting the interest rate differences between two currencies or other financial instruments, considering the costs and yields over time.
### In which scenario might the cost of carry be negative?
- [ ] When storage costs are extremely high
- [ ] When the asset depreciates quickly
- [x] When the yield from the asset exceeds carrying costs
- [ ] When insurance premiums increase
> **Explanation:** The cost of carry can be negative when the yield or income from the asset, such as interest or dividends, exceeds the associated carrying costs.
### How does the cost of carry impact futures pricing?
- [x] It is added to the spot price
- [ ] It is subtracted from the spot price
- [ ] It has no impact on futures pricing
- [ ] Futures are priced independently of carry costs
> **Explanation:** Cost of carry is a factor added to the spot price of an asset to determine its futures price, reflecting expenses for holding the asset until the maturity date.
### Which asset is least likely to have a significant cost of carry?
- [ ] Physical gold
- [ ] Crude oil
- [ ] Real estate
- [x] Government bonds
> **Explanation:** Government bonds typically have minimal carrying costs as they do not require storage, maintenance, or special insurance like physical commodities or real estate.
### What is a primary cost of carry associated with real estate?
- [ ] Dividend payments
- [ ] Capital gains taxes
- [x] Property taxes
- [ ] Trading fees
> **Explanation:** Holding real estate involves property taxes, which constitute a significant portion of the carrying costs, alongside mortgage interest, insurance, and maintenance.
### For which type of investment is financing cost a major component of the cost of carry?
- [ ] Mutual funds
- [x] Margin trading
- [ ] ETFs
- [ ] Bond trading
> **Explanation:** In margin trading, investors borrow funds to purchase assets. The interest on these borrowed funds is a substantial component of the total cost of carry for such investments.
### What could reduce the cost of carry for an inventory asset?
- [ ] Increasing borrow rates
- [x] Efficient warehouse management
- [ ] Higher insurance premiums
- [ ] Extending storage periods
> **Explanation:** Efficient warehouse management can reduce storage costs, thereby lowering the overall carrying costs for an inventory asset.
### Which field deals extensively with evaluating cost of carry for materials?
- [ ] Auditing
- [ ] Tax accounting
- [x] Inventory management
- [ ] Payroll accounting
> **Explanation:** Inventory management involves the continuous assessment of storage, insurance, and other maintenance costs, which are integral to understanding the cost of carry for materials.
### What calculation is influenced by the cost of carry?
- [ ] Profit margin
- [x] Futures contract pricing
- [ ] Depreciation
- [ ] Gross revenue
> **Explanation:** Futures contract pricing is directly influenced by the cost of carry, as it accounts for expenses related to holding the underlying asset until the contract's delivery date.
Thank you for exploring the concept of the “Cost of Carry” with us and challenging yourself with our quiz questions. We hope this deep dive enriches your understanding of financial metrics!
