Absolute carry cost: Meaning, Criticisms & Real-World Uses

What Is Absolute Carry Cost?

Absolute carry cost refers to the total expenses incurred when holding an investment or physical asset over a period. This financial category, primarily relevant in derivatives markets and commodity trading, encompasses various charges, including storage fees, insurance premiums, and the interest expense on funds used to finance the asset. Understanding absolute carry cost is crucial because it directly impacts the profitability of holding a particular asset, especially in strategies like arbitrage.

History and Origin

The concept of carry cost, in its fundamental sense, has been implicitly understood for centuries by merchants and traders dealing in physical goods. Any individual holding inventory, whether it be grain or spices, inherently faced costs associated with storage, spoilage, and the financing of their stock. However, the formalization and explicit calculation of carry cost became particularly significant with the emergence and growth of futures markets.

Modern futures trading began to take shape in the mid-19th century in the United States, notably with the establishment of the Chicago Board of Trade (CBOT) in 1848, which introduced standardized "forward contracts" and later "futures contracts" for agricultural products in 1865.¹³, ¹⁴ As these markets developed, the explicit consideration of the costs involved in holding a physical commodity until its future delivery date became vital for pricing futures contracts accurately. This gave rise to the theoretical framework that integrates elements like storage, insurance, and financing costs into the futures price, thereby quantifying the absolute carry cost. The Chicago Mercantile Exchange (CME), founded in 1919, also played a pivotal role in expanding financial futures beyond agricultural products to include foreign currency and interest rate products in the 1970s, further embedding the concept of carry cost into financial instruments.¹¹, ¹²

Key Takeaways

Absolute carry cost represents all expenses associated with holding an investment or physical asset over time.
It is a critical factor in the pricing of futures and forward contracts, particularly for commodities.
Components typically include storage, insurance, and financing costs, along with any opportunity costs.
In commodity markets, a positive absolute carry cost often leads to a market condition known as contango.
High absolute carry costs can erode returns for investors holding long positions.

Formula and Calculation

For a physically delivered commodity, the absolute carry cost plays a direct role in determining the theoretical futures price. The relationship between the spot price and the futures price, including the absolute carry cost, can be expressed using the cost of carry model.

The formula for the futures price (F) incorporating the absolute carry cost is often given as:

F = S \times e^{(r + s - c)t}

Where:

(F) = Futures price
(S) = Spot price of the underlying asset
(e) = The base of the natural logarithm (approximately 2.71828)
(r) = The risk-free interest rate (cost of financing)
(s) = Storage cost, expressed as a percentage of the spot price (for physical commodities)
(c) = Convenience yield (benefit of holding the physical asset, often 0 for financial assets)¹⁰
(t) = Time to delivery of the contract, expressed as a fraction of one year

This formula highlights how interest rates and storage expenses directly contribute to the absolute carry cost, influencing the forward price of an asset.

Interpreting the Absolute Carry Cost

Interpreting the absolute carry cost is essential for participants in futures and forward markets. A positive absolute carry cost indicates that it is more expensive to hold an asset for future delivery than to purchase it immediately. This situation typically results in a market structure known as contango, where the futures price is higher than the current spot price. In a contango market, the upward slope of the futures curve reflects these accumulating carrying charges over time.⁹

Conversely, if the futures price is lower than the spot price, the market is in backwardation.⁸ While this can sometimes imply a negative absolute carry cost, it's more often due to a high convenience yield or immediate supply shortages making the spot asset more valuable. Understanding whether a market is in contango or backwardation, driven by the underlying absolute carry cost, helps traders and investors anticipate price movements and manage risk.

Hypothetical Example

Consider an investor, Sarah, who wants to analyze the absolute carry cost for a hypothetical crude oil futures contract.

Current spot price of crude oil (S) = $80 per barrel
Risk-free interest rate (r) = 5% per year (0.05)
Storage cost (s) = 2% of the spot price per year (0.02)
Convenience yield (c) = 0% (since Sarah is not a direct user of the physical oil)
Time to delivery (t) = 0.5 years (for a 6-month futures contract)

First, calculate the exponent value:
(r + s - c = 0.05 + 0.02 - 0 = 0.07)

Next, calculate (e^{(r+s-c)t}):
(e^{{(0.07 \times 0.5)} = e}{0.035} \approx 1.0356)

Finally, calculate the theoretical futures price (F):
(F = S \times e^{(r+s-c)t} = 80 \times 1.0356 \approx $82.85)

The difference between the futures price ($82.85) and the spot price ($80) is approximately $2.85. This $2.85 represents the absolute carry cost for holding one barrel of crude oil for six months under these assumptions. This cost accounts for the interest Sarah would lose on the $80 if she bought the oil outright today, plus the cost of storing it for six months. This concept is fundamental to futures pricing.

Practical Applications

Absolute carry cost has several practical applications across various financial sectors. In commodity markets, it's crucial for understanding the pricing of futures contracts. For instance, in the crude oil market, contango (where futures prices exceed spot prices) is often attributed to the absolute carry cost, including storage and financing.⁷ When storage facilities become full, the increasing cost of storage can exacerbate contango.

For portfolio managers, absolute carry cost influences decisions regarding physical asset holdings versus futures positions. If the cost is high, it may incentivize selling physical inventory and buying futures to defer delivery. In interest rate futures markets, carry cost refers to the differential between the yield on a cash instrument and the cost of funds required to buy that instrument, impacting the profitability of basis trades.⁶ Furthermore, in options trading, the absolute carry cost of the underlying asset is a component of option pricing models, affecting both call and put option values. This highlights its broad relevance in financial analysis.

Limitations and Criticisms

While the concept of absolute carry cost is fundamental, it does have limitations and criticisms. One significant challenge lies in accurately estimating all components, especially for physical commodities. Storage costs can vary based on location and availability, and insurance premiums may fluctuate. The risk-free rate itself can be debated, as no truly "risk-free" investment exists, and different proxies might be used.⁵

Moreover, the convenience yield, which reduces the effective absolute carry cost, is an implied return and can be difficult to quantify precisely. It is inversely related to inventory levels, meaning it changes as supply conditions shift.⁴ Critics also point out that in real-world markets, factors beyond theoretical absolute carry cost, such as sudden supply shocks, geopolitical events, or unexpected demand shifts, can lead to market anomalies like sudden backwardation, disrupting typical carry relationships.², ³ Such unexpected events can make strategies based solely on carry cost unprofitable or even lead to losses, demonstrating that market dynamics are not always perfectly aligned with theoretical models.

Absolute Carry Cost vs. Carrying Value

Absolute carry cost refers to the direct expenses incurred when holding an asset over a period, such as storage fees, insurance, and the financing interest. It is a flow concept, representing the ongoing outlays to maintain a position. For example, for a commodity, it's the cost to literally "carry" it from one point in time to another.

In contrast, carrying value, often used in accounting, represents the book value of an asset on a company's balance sheet. It is the original cost of the asset minus any accumulated depreciation or impairment losses. Carrying value is a stock concept, a snapshot of an asset's worth at a specific point in time, and does not directly refer to the recurring expenses of holding it. While absolute carry cost can influence an asset's perceived economic value, it is distinct from its accounting carrying value.

FAQs

What are the main components of absolute carry cost?

The primary components of absolute carry cost typically include storage expenses (for physical goods), insurance costs, and the interest expense incurred on funds borrowed to finance the asset.

How does absolute carry cost affect futures prices?

In a normal market, a positive absolute carry cost leads to futures prices being higher than current spot prices, a condition known as contango. This premium compensates for the cost of holding the asset until the future delivery date.

Is absolute carry cost always positive?

For most physical commodities, absolute carry cost is typically positive due to storage and financing expenses. However, the effective carry (futures price minus spot price) can be negative if there's a strong convenience yield, leading to backwardation.¹

How does interest rate changes impact absolute carry cost?

An increase in interest rates generally increases the financing component of absolute carry cost, making it more expensive to hold an asset. Conversely, a decrease in interest rates reduces this component. This directly influences the theoretical futures price.

Can absolute carry cost be negative?

While the fundamental components of storage, insurance, and financing are usually positive, the net carry (futures price minus spot price) can effectively be negative when there is a significant convenience yield. This happens when holding the physical asset provides a benefit (e.g., ability to meet immediate demand) that outweighs the direct costs, leading to backwardation.