The High Cost of Carry Trades and Their Impacts on the Markets

On January 12, 2009 I made note of the oil futures opening prices. The February contract was at $38.49. The July at $52.37. This was the largest contango in the oil market that I had ever seen. The price difference between these futures contracts was $13.88. That put the cost of a six-month rollover of a long position equal to 36%. That will kill any long.

The causes of this exceptional premium for ownership were varied. The credit crunch, the shortage of storage capacity and the broad market chaos back then were the primary factors. I hate negative carry trades. Getting charged 36% to own something just does not interest me. That is not to suggest that there is not money to be made. You just have to be a very good trader to succeed. The big contango scared out the longs back then. That liquidation is one of the reasons the price of crude has doubled since January.

On Friday the crude futures closing prices were:

July Delivery……….73.56
January Delivery…...75.47

The cost of the six-month roll today is $1.91. This cost of ownership is a much more modest 3% a year. This transaction cost is no longer a factor in the decision, “Should I be long oil?”.

I do not think that looking at these ‘costs’ have much predictive value. They are just another part of the puzzle. It is my observation that when the ‘cost of carry’ gets to extreme levels the underlying (stock/bond/commodity) gets illiquid. Risk takers back off, pricing for longer-term maturities becomes hard to find. Volatility increases in the short term.

Oil has doubled in the past few months because of some green shoots and a growing reality that the global economy was in fact not going to fall apart. The collapse of the contango since January has helped support this price move as well.

I look for high cost of carry trades. There are others out there.

Not in the S&P or the gold futures. S&Ps naturally trade at forward discounts. Gold is essentially flat. However, within the stock market there are some interesting negative carry trades.

If you want to be short a stock you have to borrow it. That has to be done before you get short if you plan to put a position on for a while. The cost of borrowing stocks is all over the lot. If you need to borrow Bank of America (BAC) you can borrow as much as you want for next to nothing. That is generally the case for big caps. However is you want to borrow Sears’s (SHLD) stock to get short you will pay north of 20% per annum. About 2% a month. That might not dissuade you from taking a position if you believe the stock will be 10% lower in that month. However, if you were looking for a strategic short in the retail space to balance a net long position you would probably stay away from Sears. 20% a year is after all, 20% a year.

Another example of ‘high borrow’ costs is in the solar space. To borrow either Suntech Power (STP) or Sun Power (SPWRA) look to pay about 1/2% per month. Not too bad. But if you are looking to short Canadian Solar (CSIQ) you are looking at a cost of nearly 3% per month, more than 30% per year. That is an expensive short. The timing and execution has to be near perfect for this to be a winner,

Treasury Bond futures have very big forward discounts currently. This is a reflection of the steepness in the curve. Friday’s numbers:

June………..116
December.…113

If you are long bond futures and roll for six months you earn 3. Sounds like peanuts. Now lever it twenty times and you have a 50+% return on equity. Of course if bond prices go down this positive carry can be lost in a few hours. In bond land this carry trade is pretty compelling. The flip side is if you believe that interest rates are going higher you have to pay this price to be short. Only very good traders will profit from this. This poses a dilemma for the bond crew. They are convinced that rates have to go higher but at the same time the leveraged long returns are the best they have been in 20 years.

When a compelling short is confronted with a very high cost of carry the market avoids taking long-term positions. The market expresses its views on a very short-term basis. The consequence is a higher degree of volatility and less liquidity. It is not of great significance in the share price of Sears or Canadian Solar. It is of great significance if it were to impact the government bond market.

The price action in the bond market over the past two months has been as fast as I can remember. Treasury/Fed have engineered the steep yield curve. It is necessary to repair the balance sheets of the battered financials. It is possible that the steep yield curve will result in less liquidity and more price volatility in the bond market. With $1 trillion of coupons to sell it could not happen at a worse time. Possibly this is another of those unintended consequences we keep hearing about,

The solution is at hand. Raise short rates. That is the one thing that is not going to happen any time soon.

Note: To my knowledge there is no public information source on the cost of borrowing stocks. I got the information in this piece regarding Sears and the solar stocks from my broker. They do not give this information out. You have to ask, “What will it cost me to borrow 10,000 shares of ABC stock”. This price could be double what I could have gotten it for elsewhere. There is nothing to compare that price to. There are reasons why these borrowing costs vary so widely. My guess is that supply and demand driven by investors' interests are the primary factors. Manipulation of this would be relatively easy to accomplish in the smaller cap names.

Does anyone have a good source for these costs? Should there be some public pricing here? This is investor information that could be significant. It is just not in the public domain.

Comments

[jbde:]

Where does the 'cost' to borrow a stock come from?
Broker fee?

I thought the only true cost was the liability to pay dividends to the new 'owner' who buys the shorter's sell.

The loaner gives up voting rights as they go to the new 'owner' of the borrowed stock sold by the shorter. That's no cost.

Jun 17 10:34 AM

[Bruce Krasting:]

Not correct. You have to pay to borrow. In some cases this is next to no cost, I others, as in the Sears case you have to pay a big price to borrow stock.

Jun 17 04:11 PM

[DONE_SONZ:]

If you want to be short a stock you have to borrow it. That has to be done before you get short if you plan to put a position on for a while.-No mention of naked short selling?Thats what really causes the problems.

Jun 17 04:43 PM

[Skaterdude:]

I don't understand the negative carry in the oil contracts you cited. Isn't the carrying cost outside the futures market? I.e., the cost to store oil delivered in February until delivery on a short contract for July isn't related to the gap in the contracts. Or are you saying that the implied carrying cost is high, because it's reflected in the differential between the contracts because of this arbitrage?

Thanks for an informative article.

Jun 23 08:21 PM