In the context of forwards pricing, what happens when the cost of carry increases?

• A. The fair future price decreases
• B. The fair future price remains unchanged
• C. The fair future price increases
• D. The fair future price fluctuates

Answer: (C)

In the context of forwards pricing, the cost of carry refers to the costs associated with holding an asset over time, which can include storage costs, financing costs, and any income the asset might generate (like dividends or interest). When the cost of carry increases, it has a direct impact on the fair future price of the asset being considered in a forward contract.

As the cost of carry rises, the total cost of holding the asset until the future delivery date also increases. Consequently, in order to maintain market equilibrium and compensate for these higher carrying costs, the fair future price of the asset must increase. This ensures that investors are adequately compensated for the additional costs incurred in holding the asset. Therefore, an increase in the cost of carry typically results in a higher fair future price.

This relationship is crucial to understanding how forward contracts are priced and how they respond to changes in underlying economic conditions, specifically the dynamics around carrying costs.