Chartered Financial Analyst (CFA) Practice Exam Level 2

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What is the purpose of the Cost of Carry Model?

To compute the intrinsic value of options
To relate spot price to future price
To analyze credit default swaps
To assess company-specific risks

The correct answer is: To relate spot price to future price

The Cost of Carry Model is primarily used to relate the spot price of an asset to its future price. This relationship is essential in various finance applications, particularly in futures markets. The model calculates the theoretical future price of an asset by taking into account not only the current spot price but also the costs associated with holding that asset until the future contract expires. These costs may include storage costs, financing costs, and income from the asset, such as dividends or interest. By establishing this connection, the model helps traders and investors understand the pricing dynamics between the spot and future markets, allowing them to make informed decisions about trading strategies and hedging. The ability to determine whether an asset is fairly priced in the futures market relative to its current value is a critical component of risk management and investment strategy.