Question

What are the disadvantages to the cost of carry model for pricing futures contracts?

Answer 1

Cost of carry means the cost of holding the Asset till the maturity So, in the terms of future contracts, cost of carry is an important measure as future contract has specified maturity, so the return have to be made until that date, or the investor will have to suffer loss at maturity.

Various disadvantages of cost of carry model for pricing future contracts are as follows-

A. It can be disadvantagious, if if the prices does not run according to the expectation and it started to go in opposite direction, the investor will make losses.

B. It will have maturity date, as the contract will expire at the time of the maturity and investor will have to make profits before the date of maturity so there is a time constraint

C. Investor also take high amount of leverage in future contracts, so the losses can be magnified due to holding of asset for longer period of time.

D. The volatility is generally higher in the derivative segment, so holding of assets can be lethal if the movement is on the opposite side, because it can blow off the entire account of trader.

E. Cost of carry model can even lead to triggering of the Margin calls of traders.