What Is a Carrying Charge?
A carrying charge is the cost associated with storing a physical commodity or holding a financial instrument over a defined period of time. Carrying charges include insurance, storage costs, interest charges on borrowed funds and other similar costs. As carrying charges can erode the overall return on an investment, due diligence should be given to them in considering the suitability of the investment and also while evaluating investment alternatives. This term is sometimes referred to as cost of carry.
Understanding Carrying Charge
Carrying costs can be a deterrent for retail investors who wish to invest in physical commodities since storage and insurance costs can be quite significant and a burden to navigate. Such investors may be better served by commodity exchange-traded funds, which have surged in popularity in recent years.
Carrying charges are generally incorporated into the price of a commodity futures or forward contract. Under normal market conditions, therefore, the price of a commodity for delivery in the future should equal its spot price plus the carrying charge. If this equation does not hold, due to abnormal market conditions or some other development, a potential arbitrage opportunity may exist.
Carry Charge Arbitrage Example
Assume that the spot price for a commodity is $50 per unit, and the one-month carrying charge associated with it is $2, while the one-month futures price is $55. An arbitrageur could pocket a risk-free profit of $3 per unit in this case by buying the commodity at the spot price and storing it for a month, while simultaneously selling it for delivery in a month at the one-month futures price. This process is known as cash-and-carry-arbitrage. It is a market-neutral strategy combining the purchase of a long position in an asset, such as a stock or commodity, with the sale (short) of a position in a futures contract on the underlying asset.
This trading strategy is very popular in the oil market when tanker freight rates are reasonable and the futures curve is steep, meaning oil prices in the future are higher than they are right now. Oil producers can produce a barrel of oil and store it on a ship for a specific period of time and then sell that same barrel in the future at a higher price. If the carrying charge to keep the oil on the ship is less than the difference between the spot and future prices, the producer will make a larger profit by selling that barrel of oil in the future instead of on the spot market.