Question

The spot price of oil is $80 per barrel and the cost of storing a barrel of oil for one year is $3, payable at the end of the year. The risk-free interest rate is 5% per annum, continuously compounded. Assume that transaction costs are negligible.

Can we give a lower-bound?

What are the difficulties of using the cost-of-carry model for commodities held for consumption?

Answer 1

A lower-bound for the future price = S0ert + cost of storage = 80 x e5% x 1 + 3 = $  87.10 per barrel

the difficulties of using the cost-of-carry model for commodities held for consumption

• These are held for consumption and not investment
• these items are subjectd to wastage, evaporation losses, shrinkage in volume when stored
• these items are perishable, they may get spoilt while storing

Hence, the cost of carry model may not be suitble for valuation of commodities held for consumption.