What is a Carrying Charge Market
Carrying charge market is 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 a more extended period. Because a carrying charge market incorporates the full cost to carry a commodity, it is also known as a full carry market.
BREAKING DOWN Carrying Charge Market
In the carrying charge marketplace, a contract's price will increase in correlation to the duration of the contracts involved. This increase in price is because cows have to eat and gold has to be kept secure. A carrying charge is costs connected with storing a physical commodity until the delivery or expiration of the contract. These charges include insurance, storage costs, interest charges on borrowed funds and other similar expenses.
Futures contracts offering lower prices for short-term trading can represent an indicator of the price difference in a carrying charge market. Comparison of the cost of a short-term contract to the increased prices for a similar longer-term contract will illustrate the carrying cost.
Unexpected Fluctuations in a Carrying Charge Market
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 causing 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.
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 might 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.