What Is Positive Carry?
The term positive carry refers to a strategy that involves two different positions where the inputs end up being greater than the outputs. Investors often use a positive carry strategy by investing borrowed capital and making a profit on the difference between interest earned and interest paid. This strategy is commonly used in foreign exchange markets, where investors can exploit the relative strengths and weaknesses of various currencies. Positive carry is the opposite of negative carry.
Key Takeaways
- Positive carry is a strategy that relies on investing borrowed money and earning a profit on the difference between the return and the interest owed.
- Investors commonly use positive carry in currency markets.
- A trader can borrow money in a weak currency, invest it in a strong currency, and pocket the difference between the loan cost and the investment’s return.
- Traders who use positive carry keep an eye on the Federal Reserve, whose activities affect currency rates around the world.
- Positive carry is the opposite of negative carry, which means the cost of an investment is more than its returns.
How Positive Carry Works
Investing involves the use of money and allocating it into one or more assets to generate a profit. These assets may be stocks, bonds, businesses, or even real estate. When an investor makes an investment in a certain asset, they generally expect to hold it until the price goes up to ta certain level and sell it in order to make money. They may have to use one or more strategies to achieve this goal.
One investment strategy that investors use is called positive carry. As noted above, this strategy commonly involves the use of leverage to earn a profit. An investor who uses positive carry normally borrows money and invests that sum in an asset with the hope that the investment will generate a higher return than the interest they have to pay on the loan. Any difference between the two (the return less the interest owed) ends up being a profit.
Here’s a simple way to show how positive carry works. Let’s say you get a credit card with a $5,000 credit limit and an intro annual percentage rate (APR) of 0% for 15 months. A month after you activate the card, you decide to make some money off it by investing that $5,000 in a year-long certificate of deposit (CD) that pays you 1% interest. This means you’ll end up 1% richer once the CD matures provided you make the minimum payments on the card. You can use the principal from the investment to pay off the remaining balance on your credit card.
This strategy can work in multiple currencies on multiple exchanges. And the interest that an investor can get on an investment in one currency may be more than the interest the same investor has to pay to borrow in another currency. For instance, an investor may borrow in a low-yielding currency, such as the Japanese yen (JPY), then exchanges it for a high-yielding currency, such as the Australian dollar (AUD). The money is then invested in AUD. The difference between the yield on the Australian investment and the payment on the Japanese loan is the profit.
You may have heard of a carry trade, which is similar to positive carry. A carry trade involves using borrowed capital at a low interest rate and investing it in assets that provide high rates of return. This strategy commonly involves borrowing in a currency with a low interest rate and converting that capital into a currency with a higher interest rate.
Special Considerations
Positive carry uses some of the tactics of arbitrage. This is the practice of exploiting the price difference between two or more exchanges. Markets, and particularly markets that trade in different currencies, are not always perfectly in sync with one another. Traders who specialize in arbitrage take advantage of this fact.
Arbitrage exists as a result of market inefficiencies. For example, at any single moment, Company A might trade at $30 on the New York Stock Exchange (NYSE) but at $29.95 on the London Stock Exchange (LSE). A trader can purchase the stock on the LSE and immediately sell it on the NYSE, and earn a profit of five cents per share.
Arbitrage relies on minuscule errors that occur between markets, such as New York and London pricing, or London and Tokyo pricing. Advanced technologies, such as high frequency and computerized trading, make it far more challenging to profit from these kinds of market pricing errors. These days, any price differences in similar financial instruments are quickly caught and corrected.
The low-yielding Japanese yen and the high-yielding Australian dollar are often paired by traders who use positive carry as a trading strategy.
Positive Carry vs. Negative Carry
Positive carry can be contrasted with negative carry. Negative carry involves holding an investment whose income ends up being less than the cost of holding it. Put simply, it costs more money to hold an investment than its returns. This isn’t a strategy that investors want to undertake as it means they end up losing money. But investors may end up experiencing a negative carry at some point if the value of their investment drops while they hold it.
Positive Carry and the Federal Open Market Committee (FOMC)
Trades involving positive carry are heavily reliant on the activities of the Federal Open Market Committee (FOMC). This is the branch of the U.S. Federal Reserve Board that determines the nation’s monetary policy and implements it by buying or selling U.S. government securities on the open market. These decisions affect interest rates on securities worldwide.
For example, to tighten the money supply in the United States and decrease the amount available in the banking system, the Fed will decide to sell government securities. Any securities the FOMC purchases will be held in the Fed’s System Open Market Account (SOMA). The Federal Reserve Act of 1913 and the Monetary Control Act of 1980 granted the FOMC permission to hold these securities until maturity or sell them when they see fit. The Federal Reserve Bank of New York executes the Fed’s open market transactions.
Wall Street scrutinizes the reports that come out of the eight annual meetings of the FOMC to figure out if the committee will embark on a policy of tightening, will remain on hold and not change interest rates, or will raise rates to slow inflation.
The Federal Reserve raised the fed funds rate for the first time since 2018, hiking them 25 basis points to a range of 0.25% to 0.5%. The announcement was made in the March 2022 FOMC meeting.
Example of Positive Carry
As we already established, positive carry uses borrowed capital to earn a profit. And it often involves currency trading. Just how does it work? Here’s a hypothetical example to show how the strategy is executed.
Let’s consider using just one currency—in this case, the U.S. dollar. An investor borrows $1,000 from a bank at 5% interest, then invests that $1,000 in a bond that pays 6% interest. The interest on the bond pays 1% more than the payment on the loan. The investor pays off the loan and pockets the 1% difference. This strategy would certainly work nicely if the investor could consistently find bonds that pay more in interest than loans cost to pay off.
How Does Positive Carry Work?
Positive carry involves generating a profit by using borrowed capital for investment purposes. The profit is the difference between the investment return and the interest owed on the borrowed capital. It is commonly used to exploit differences in currencies in foreign exchange markets.
What’s the Difference Between Positive Carry and Negative Carry?
Positive carry involves making a profit by investing in an asset using borrowed capital. The difference between the investment’s return and the interest owed is the profit. Negative carry, on the other hand, happens when an investor loses money on an investment. Investors end up with experiencing a negative carry strategy when the cost of holding an investment is more than its return.
What Is a Carry Trade?
A carry trade involves the use of low-interest borrowed capital and investing it into an asset that generates a higher return. This strategy is commonly employed in foreign exchange markets, where the capital is borrowed in a low-interest currency and is invested in a currency with a higher interest rate.
