Carry (investment)

From Wikipedia, the free encyclopedia

The carry of an asset is the return obtained from holding it (if positive), or the cost of holding it (if negative).

For instance, commodities are usually negative carry assets, as they incur storage costs, but in some circumstances, commodities can be positive carry assets as the market is willing to pay a premium for availability.

This can also refer to a trade with more than one leg, where you earn the spread between borrowing a low carry asset and lending a high carry one.

Carry trades are not arbitrages: pure arbitrages make money no matter what; carry trades make money only if nothing changes -- but things may change.

1 Interest rates
2 Currency
3 Notes
4 See also
5 External links

[edit] Interest rates

See also: Interest rates

For instance, the traditional income stream from commercial banks is to borrow cheap (at the low overnight rate, i.e., the rate at which they pay depositors) and lend expensive (at the long-term rate).

This works in an upward-sloping yield curve, but it loses money if the curve becomes inverted. The floating of short-term rates, for example, when Paul Volcker was the chairman of the Federal Reserve resulted in exactly this problem and was the root of the Savings and Loan crisis.

According to a popular anecdote, traditional commercial banking can be characterized as a "3-6-3" business: borrow at 3%, lend at 6% (thus earning the 3% spread), be on the golf course by 3 pm. ^[1]

[edit] Currency

See also: Foreign exchange market

The term carry trade without further modification refers to currency carry trade: investors borrow low-yielding and lend high-yielding currencies. It tends to correlate with global financial and exchange rate stability, and retracts in use during global liquidity shortages.^[2]

The risk in carry trading is that foreign exchange rates may change to the effect that the investor would have to pay back more expensive currency with less valuable currency.^[3] In theory, according to uncovered interest rate parity, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate one. However, carry trades weaken the target currency, because investors sell the borrowed sum and convert it to other currencies.

By early year 2007, it was estimated that some US$1 trillion may be staked on the yen carry trade.^[4] Since the late-1980's, the Bank of Japan has set Japanese interest rates at very low levels making it profitable to borrow Japanese yen to fund activities in other currencies. Many of these activities included matters like subprime lending in the USA, yet also include funding of emerging markets, especially BRIC countries and resource rich countries.