This model assumes that arbitrage between the cash market and the futures market eliminates all imperfections in pricing, i.e., unaccounted for differences between the cash price and futures price. The difference that remains is due to a factor called ‘the cost of carry’. The model also assumes, for simplicity sake, that the contract is held till maturity, so that a fair price can be arrived at.
To put it briefly, once all distortions in the futures price have been erased by arbitrage, a fair futures price = the spot price + the net cost of carry of the asset from today to the date on which the contract expires.
The net cost of carry involves all costs that you may have had to incur in order to hold a similar position open in the cash market, less the returns that you would have received from this position. The costs typically include financing charges, at the prevailing rate of interest. This is because you may have borrowed to finance a similar position in the cash market, and if not, you may have lost interest on the capital that you invested to keep your position open. In contrast in the futures market, you merely have to deposit a fraction of the value of your position in the form of a margin. The returns that you receive could consist of dividends or bonuses that you may have received in case you had held stocks in the cash market. In the case of an index future, your returns may be gauged by the average return that an index delivers.
As this theory is modified to become more realistic, by discarding assumptions or including variables, it becomes more complex. However, what you must absorb from this theory is the fact that there are costs and benefits involved in keeping a position open in a cash market and the price of a futures contract charges you or compensates you to reflect these.
Cost of Carry or CoC is the cost to be incurred by the investor for holding certain positions in the underlying market till the futures contract expires. The risk-free interest rate is included in this cost. Dividend payouts from the underlying are excluded from the CoC.
CoC is the difference between the futures and spot price of a stock or index. The Cost of Carry is important because higher the value of CoC, higher is the willingness of the traders to pay more money for holding futures.
Theoretically, Future price fair value=Spot Price+Cost of Carry-Dividend Payout Cost of Carry = Difference between the futures and spot price at any time
CoC is calculated as an annual rate and expressed in percentage values. The real-time CoC values are available on stock exchange websites.
The value of CoC is used as an indicator to understand the market sentiment i.e. Low CoC means there is a fall in the value of the underlying and vice versa.
Traders often refer to CoC to guage market sentiment. Analysts interpret a significant fall inCoC as an indicator of an impending fall in the underlying. For example, CoC of benchmark index Nifty futures dropped by nearly half a fortnight ago,and served as an indicator of the consequent correction in the index.Conversely, when the CoC for a stock future rises, it means that traders are willing to incur higher costs for holding the position and,thus,expect a rise in the underlying. CoC is expressed as an annualized figure in percentage.
CAN COST OF CARRY BE NEGATIVE?
Yes. When futures trade at a discount to the underlying, the resultant cost of carry is negative. This usually happens for two reasons: when the stock is expected to pay a dividend,or when traders are aggressively executing a “reverse arbitrage” strategy, which involves buying spot and selling futures. Negative cost of carry points to bearish sentiment
HOW DOES COST OF CARRY REPRESENT BULLISHNESS OR BEARISHNESS?
Change in CoC seen along with open interest shape a clear picture of broader sentiment for the stock or index. Open interest is the total number of open positions in a contract. For a rising OI,an increase in CoC indicates accumulation of long(or bullish) positions, while an accompanied fall in the CoC indicates addition of short positions and bearishness. Likewise, a fall in OI,accompanied with a rise in CoC, indicates closure of short positions. A falling both OI and CoC indicates that traders are closing long positions. Analysts also observe changes in CoC at the expiry of derivatives contract. If a significant number of positions are rolled over with a higher cost of carry,it implies bullishness.