Introduction

In the realm of commodity markets, the cost of carry model plays a pivotal role in determining the pricing dynamics of forward contracts. This model encompasses various factors such as storage costs and convenience yields that significantly influence the pricing of commodity forwards. Understanding the interactions between these elements and their impact on forward prices is essential for traders, investors, and market participants. In this chapter, we will delve into the intricacies of the cost of carry model, exploring its components, calculations, and the profound implications it holds for commodity trading.

Cost of Carry Model

The cost of carry model is a fundamental framework used to assess the relationship between the spot price of a commodity and its corresponding forward price. It considers the expenses associated with holding the commodity over a specified period, encompassing storage costs, interest rates, and convenience yields. Storage costs refer to the expenses incurred in storing the physical commodity, including warehousing, insurance, and handling costs. Interest rates factor in the opportunity cost of tying up capital in the commodity. Convenience yields reflect the benefits gained from holding the physical commodity, such as the ability to meet sudden demands or capitalize on short-term opportunities.

Impact of Storage Costs and Convenience Yields

Storage costs and convenience yields exert a significant influence on commodity forward prices. When storage costs increase, the carrying cost of holding the physical commodity rises, leading to higher forward prices compared to spot prices. Conversely, if storage costs decrease, the differential between forward and spot prices may decrease as well. Convenience yields, on the other hand, serve as a positive factor that can lead to a higher forward price relative to the spot price. Commodities with higher convenience yields tend to exhibit more pronounced differences between forward and spot prices.

Example: Let’s consider a scenario where a trader is assessing the forward price of crude oil. If the costs associated with storing crude oil increase due to limited storage availability, the forward price may exceed the spot price. This reflects the higher carrying costs incurred by the trader due to increased storage expenses. Conversely, if convenience yields for gold rise due to increased demand for jewelry production, the forward price of gold may experience an upward shift relative to the spot price.

Commodity Forward Price and No-Arbitrage Bounds

The cost of carry model provides valuable insights into the bounds within which commodity forward prices should fall. These bounds are established by the interactions of storage costs, interest rates, convenience yields, and the time to maturity of the forward contract. If the forward price deviates significantly from the computed bounds, arbitrage opportunities may arise, prompting traders to buy or sell the commodity to exploit the pricing discrepancy.