Carry (investment)

The carry of an asset is the return obtained from holding it (if positive), or the cost with 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: they make money if nothing changes, but things may change.

Interest rates

See 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 loses money if the curve becomes inverted. The floating of short-term rates when Paul Volcker was the chairman of Federal Reserve caused exactly this problem, and was the seed of the Savings and Loan crisis.

Some characterized traditional commercial banking 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.

Currency

See foreign exchange market

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

The risk of carry trades is that foreign exchange rates will change, and the investor will have to pay back now more expensive currency with less valuable currency. In theory, 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 what they have borrowed, and convert it into other currencies.

For example, a trader borrows 1,000 yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Assuming the bond pays 4.5% and the Japanese interest rate is set at 0%, the trader stands to make a profit of 4.5% (4.5% - 0%), as long as the exchange rate between the countries does not change. Leverage can make this type of trade very profitable. If the trader above uses a leverage factor of 10:1, then he/she can stand to make a profit of 45% (4.5% * 10). However, if the U.S. dollar were to fall in value relative to the Japanese yen, then the trader would run the risk of losing money.

As of early 2007, it is estimated that as much as US$1 trillion may be staked on the yen carry trade.

External links

• The Yen Carry Trade Revisited
• The Trade of the Decade by Nicholas Vardy - March 6, 2007