The term carrying charge refers to the total cost associated with owning a financial instrument or physical commodity. Carrying charges will include applicable cost such as financing, storage, and insurance.
Whenever an investor chooses to own a stock, bond, or physical commodity, they need to understand the total cost of ownership. Carrying charges are those costs the investor must pay to own the asset over time. As such, it’s important to quantify these costs since they can erode the return on investment.
Typical carrying charges include financing costs, which are the interest charges levied on borrowed funds. When applied to physical commodities, carrying charges can also include the cost to transport, store, and insure the asset against hazards.
When the price of a forward contract or commodity future is quoted, it will usually include carrying charges. This is because the cost to deliver a commodity in the future should include both the cost to purchase the asset (its spot price) plus the associated carrying charges. If the quoted price on a futures contract didn’t include carrying charges, the investor would be presented with an arbitrage opportunity.
The spot price of a commodity is currently $100 per standard unit, and the carrying charges associated with the asset is $10 per month. When valued correctly, the two-month future price would be equal to the spot price of the commodity plus two months of carrying charges or $100 + (2 x $10), which is equal to $120. If the futures price of the commodity were $125, an arbitrageur could purchase a unit on the spot market for $100, store it for two months for $20, sell the futures contract for $125, and earn an immediate $5 return.