Factor Cost of Carry into Your Futures Pricing

What Is Cost of Carry

Cost of carry is the net cost of holding a financial asset or physical commodity over a specific period. If you buy an asset today and plan to hold it until a future date, you incur costs such as financing, storage, or insurance, and you may also receive income like dividends or interest that offsets some of those costs.

In simple terms: Cost of Carry = Costs of Holding - Benefits from Holding. If costs exceed benefits, the net carry is positive. If benefits exceed costs, it is negative.

What's Included in Carrying Costs

The main components are:

• Financing costs: interest paid or the opportunity cost of capital tied up in the position, often proxied by the risk-free rate

• Storage costs: warehousing, insurance, and transportation, mainly for physical commodities; typically zero for electronic financial assets

• Income earned: dividends, bond interest, or convenience yield (the implied benefit of holding a physical commodity in short supply), all of which reduce the net cost of carry

A guide to how equity instruments are valued covers how dividend income affects the carry calculation for equity-based instruments.

The Cost of Carry Model and Basis

The difference between the futures price and the spot price is called the basis: Basis = Futures Price - Spot Price. Cost of carry is the factor that explains and drives this basis. Under the cost of carry model, the fair futures price should equal the spot price plus the net carrying costs over the period to expiry.

For financial assets (where storage costs are negligible), a simplified formula is commonly used: F = S x (1 + r - q)^t, where F is the fair futures price, S is the spot price, r is the financing rate, q is the expected income yield (dividends, interest), and t is the time to expiry in years.

For physical commodities, the full model adds storage costs and subtracts convenience yield: F = S x (1 + r)^t + Storage Costs - Convenience Yield. The convenience yield is an implied benefit of holding the physical commodity rather than a futures contract, particularly when supply is tight.

How Cost of Carry Links Spot and Futures Prices

The futures price should equal the spot price plus the net cost of carrying the asset until expiry. When the basis is positive (futures above spot), the net carry cost is positive. When the basis is negative (futures below spot), the benefits of holding, such as dividends or convenience yield, exceed the costs. A guide to how Brent crude oil is traded on markets covers how this relationship affects crude oil pricing specifically.

Contango and Backwardation

The cost of carry model directly explains the two main shapes of futures curves:

• Contango: futures prices sit above spot. This is the typical condition when carrying costs exceed any benefit of holding the asset. Common in commodity markets under stable supply

• Backwardation: futures prices sit below spot. This occurs when the convenience yield exceeds carrying costs, often signalling tight supply or high demand for immediate delivery

Understanding trading around commodity and macro events helps explain how supply shocks and macro events cause the curve to shift between contango and backwardation.

Conclusion

Cost of carry is the net cost of holding an asset over time, including financing, storage, and insurance, minus income earned. It is the factor that drives the basis, the difference between futures and spot prices. The simplified financial model uses interest rates and income yields; the full commodity model adds storage and convenience yield. When futures trade above spot, the market is in contango. When below, backwardation.

Risk Disclaimer: Trading involves significant risk of capital loss. This article is for educational purposes only and does not constitute financial advice. Always conduct independent research and consider your risk tolerance before making any trading decisions.