What Is a Carrying Charge Market?
In a carrying charge market, the futures price of a commodity is higher than its spot price because of the costs—or “carrying charges”—associated with physically storing that commodity.
In these markets, one can approximate the likely futures price of a commodity by taking its spot price and adding its carrying charges. However, the actual futures price will often deviate from this prediction due to forces of supply and demand.
- A carrying charge market is one in which futures prices are higher than spot prices.
- This reflects, in part, the costs associated with physically holding the underlying assets.
- From this perspective, the futures holders in a carrying charge market are willing to pay extra for the futures contract because it allows them to avoid paying these carrying charges.
How Carrying Charge Markets Work
The commodities futures markets are a large and important part of the modern financial markets. Through them, companies that rely on commodities for their operations can source them at scale in a way that minimizes counterparty risk. At the same time, commodity producers can benefit from forward hedging and price transparency, while financial buyers can use the markets to speculate on commodity prices.
Because of the wide variety of commodities traded on these markets, some commodities futures market will show different patterns of pricing. For example, commodities such as corn, gold, and crude oil will generally have futures prices that are higher than their spot prices. One of the main reasons for this is that these commodities cost money to store, due to factors such as feed for livestock, insurance for precious metals, or rent for warehouses. At the same time, these commodities do not pay any yield through dividends or interest, so owning them has a negative effect on the owner’s short-term cashflow.
Although commodity futures markets tend to follow broad patterns such as these, it is important to keep in mind that the actual futures prices will fluctuate dynamically based on a much wider set of factors. Ultimately, it is supply and demand that sets the futures prices, so these patterns do not always hold.
These types of commodity futures are known as having “carrying charge markets” because their futures prices are influenced by their carrying charges. By contrast, the same would not be true for equity index futures contracts, since in this case the underlying asset—namely, an equity index such as the S&P 500—does not have the same kinds of carrying charges. In fact, the opposite is true: people who own the companies that make up an equity index often receive dividends from their portfolio, meaning that owning these assets has a positive effect on their short-term cashflow. For this reason, equity index futures typically have futures prices that are below their spot prices, to reflect the fact that the futures owners are “missing out” on the dividend income earned by the asset holders.
Real World Example of a Carrying Charge Market
A carrying charge market can represent the fluctuations seen as a result of these types of situations. For example, if it costs $1 a month to ensure and store a bushel of corn, and the spot price is $6 per bushel, a contract for a bushel of corn that matures in three months should cost $9 in a carrying charge market. However, when a commodity is in low supply, spot prices may be higher than future prices. The increased price helps to ration the limited supply in the market. In this scenario, you could have an inverted futures curve, also known as backwardation.
In some markets, most notably the energy market, backwardation is standard. For example, assume an investor goes long with a futures grain contract at $100 which is due in one year. If the expected future spot price is $70, the market is in backwardation. In that scenario, the futures price will have to fall, or the future spot price change, to converge with the expected future spot price.