What Is a Carrying Charge?
A carrying charge is a cost associated with holding a physical commodity or financial instrument. Examples of carrying charges include insurance costs, storage costs, and interest charges on borrowed funds. These costs are also sometimes referred to as an investment’s cost of carry.
Since carrying charges increase the cost of an investment, they put downward pressure on that investment’s expected return. For this reason, investors should carefully consider the likely carrying charges involved in an investment before deciding whether to proceed.
- Carrying charges are the various costs associated with holding a commodity or financial instrument.
- The significance of carrying charges varies depending on the type of commodity or instrument in question.
- At times, mispriced carrying charges can lead to risk-free profit opportunities, such as in the case of cash-and-carry arbitrage.
How Carrying Charges Work
Carrying charges can vary substantially depending on the type of investment in question. If an investor wants to take physical delivery of crude oil, for example, then the carrying charges could quickly become quite substantial. In addition to requiring a storage vat in which to keep the oil, the investor may also incur transportation costs, labour costs, and insurance costs. In this case, the high carrying charges could potentially make the entire investment unprofitable.
In other cases, carrying costs could be much more modest. For instance, an investor who purchases an exchange-traded fund (ETF) might pay a management fee of less than 1.00% per year. In this scenario, the 1% carrying charge is unlikely to be a major factor in determining whether the overall investment was profitable. This is one of the reasons why lower-cost investments such as ETFs have become so popular in recent years, particularly among retail investors.
Oftentimes, the price of a given security will already reflect the carrying charges involved in purchasing it. For example, under normal market conditions, the price of a commodity futures contract will include not only its spot price but also the carrying charges involved in storing it.
This is because, by purchasing a futures contract instead of buying the commodity today, the buyer of the futures contract is essentially benefiting from not having to incur those carrying charges until the futures contract’s settlement date. For this reason, the price of a commodity for delivery in the future is generally equal to its spot price plus its carrying charges. If this equation does not hold, then an investor can theoretically profit from an arbitrage opportunity.
Example of a Carrying Charge
To illustrate this potential arbitrage opportunity, consider the case of a commodity whose spot price is $50. If the carrying charges associated with that commodity are $2 per month, and its one-month futures price is $55, then an investor could make a $3 arbitrage profit by simultaneously buying the commodity at the spot price and selling it for delivery in one month at its one-month futures price.
In that scenario, the investor would simply take delivery of the commodity, receive $55 from the sale of the futures contract, store it for one month, and make a risk-free profit of $3 per contract. This strategy is known as cash-and-carry arbitrage. In this example, it was made possible because the market did not accurately reflect the carrying charges of the commodity in the price of its one-month futures contract.