When pricing forward contracts, accounting for any costs or benefits tied to holding the underlying asset is essential. These include dividends, holding costs, and convenience yield—impacting the forward price. This combined effect is known as the ‘net cost of carry.’

Applying Net Cost of Carry in Forward Pricing

To calculate an asset’s forward price, we must consider whether it has a zero, positive, or negative net cost of carry.

Let’s begin with a simple scenario: pricing a forward contract where the underlying asset has no associated cash flows. Assets, however, often come with certain benefits (like dividends or convenience yield) and costs, such as storage or maintenance. These factors must be considered when determining the forward price.

How is the forward price determined in such cases?

Suppose Ben and Evelyn enter a forward contract for 100 shares of Company ABC. Unlike a basic forward, this asset includes benefits and costs.

Now, assume Company ABC pays a $1 dividend per share during the contract period. This dividend is a benefit associated with owning the asset. Who benefits from the dividend: Ben or Evelyn? It’s Ben. He receives the dividend since he holds the actual shares during the contract term.

This benefit (the convenience yield) is exclusive to the asset holder—in this case, Ben. Evelyn—who only holds the forward contract—does not receive it.

On the other hand, Ben also incurs a holding cost of $2 per share—again, a responsibility that does not fall on Evelyn.

How do these benefits and costs influence the forward price?

Benefits—like dividend income and convenience yield—reduce the forward price. Costs associated with holding the asset increase it. Why? If Ben receives income from holding the asset, he’s more willing to agree to a lower forward sale price. But if he faces holding costs, he’ll expect a higher forward price to make the contract worthwhile.

The net cost of carry captures this trade-off—often expressed as gamma minus theta (γ – θ)—where γ represents the costs of holding the asset, and θ represents the benefits. This relationship is defined as:

Net Cost of Carry = Costs (γ) – Benefits (θ)

When pricing a forward contract, remember to account for the time value of money—future cash flows are discounted accordingly. Given all known values, the forward price at expiration is:

F(T) = $12.10

This is the amount Evelyn will pay Ben at maturity to acquire the shares.

This example shows how a negative net cost of carry—where benefits outweigh costs—reduces the price of a forward contract. Using the same logic, you can calculate forward prices under zero or positive net cost of carry scenarios.

The Role of Cost of Carry in Forward Pricing

Understanding the net cost of carry is essential for accurately pricing forward contracts. By factoring in the benefits and costs of holding an asset—such as dividends, convenience yield, and storage expenses—investors can determine how these elements influence the forward price.

As previously noted, a negative net cost of carry lowers the forward price, making it a crucial concept in financial decision-making. Mastering this framework enables more precise and informed contract valuations across various market conditions.

To deepen your knowledge and gain hands-on experience with forward pricing and other key financial concepts, consider joining the 365 Financial Analyst platform.

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