What Is a Carrying Charge Market?
The term carrying charge market refers to a futures market where long-maturity contracts have higher future prices relative to current spot prices. The name comes from the fact that these higher future prices correlate with increased carrying charges, such as interest, insurance, and storage for holding the commodities for an extended period of time.
- A carrying charge market is a futures market where long-maturity contracts have higher future prices relative to current spot prices.
- A contract's price increases in correlation to the duration of the contracts involved.
- Carrying charge markets allow investors to calculate future prices by starting with the near month futures, then adding in the carrying charge
How Carrying Charge Markets Work
A carrying charge connected with storing a physical commodity until the contract's delivery or expiration date. These charges—which are also called the cost of carry—include insurance, storage costs, interest charges on borrowed funds, and other similar expenses. Investors should be wary of these costs because diminish the value of the associated investment.
In the carrying charge marketplace, a contract's price increases in correlation to the duration of the contracts involved. This increase in price occurs because cows have to eat and gold has to be kept secure. Because a carrying charge market incorporates the full cost to carry a commodity, it is also known as a full carry market. Futures contracts that offer lower prices for short-term trading can represent an indicator of the price difference in a carrying charge market. A comparison of the cost of a short-term contract to the increased prices for a similar longer-term contract will illustrate the carrying cost.
Under normal circumstances, a carrying charge market means you could calculate future prices by starting with the near month futures and adding the carrying charge. Still, it is necessary to remember that the value of any given commodity can fluctuate, depending on supply and demand. Shortages or other unexpected situations that drastically impact availability can, in turn, affect spot prices. If the condition that causes the shortage resolves quickly, the impact on prices may be for a limited time. These unforeseen circumstances explain why there are cases where the spot price may be high in comparison to the future price.
Although you may be able to calculate futures prices by adding the near month futures and the carrying charge, a commodity's price may still fluctuate because of supply and demand.
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.
Inverted curves describe a situation in which the delivery price of a particular futures contract has to move downward to meet the future expected spot price. In that some markets, most notably the energy market, inverted or backwardation is standard. For example, assume an investor goes long with a futures grain contract at $100. The contract is due in one year. If the expected future spot price is $70, the market is in backwardation, and the futures price will have to fall, or the future spot price change, to converge with the expected future spot price.