What Is Positive Carry?
Positive carry is a strategy that involves borrowing money in order to invest it to make a profit on the difference between the interest paid and the interest earned.
The positive carry strategy is most often used in the currency markets, where investors can exploit the relative strengths and weaknesses of various currencies.
Positive Carry Explained
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.
This basic fact explains how the positive carry strategy works.
- The positive carry strategy relies on the relative strength or weakness of currencies used in different exchanges.
- 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.
First, consider an example using just one currency, the U.S. dollar. An investor borrows $1,000 from a bank at 5% interest, and 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.
That would work nicely if the investor could consistently find bonds that pay more in interest than loans cost to pay off.
It can, in fact, work when the investor is dealing in multiple currencies on multiple exchanges.
Positive Carry in Action
Positive carry uses some of the tactics of arbitrage, which 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 in perfect 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, earning a profit of 5 cents per share.
The low-yielding Japanese yen and the high-yielding Australian dollar are often paired by traders using the positive carry strategy.
Arbitrage relies on minuscule errors that occur between New York and London pricing, or London and Tokyo pricing. Advanced technologies, such as high frequency and computerized trading, have made it far more challenging to profit from such pricing errors in the market. These days, any price differences in similar financial instruments are quickly caught and corrected.
Positive carry is a more consistently workable strategy. It involves borrowing money in a low-yielding currency, such as the Japanese yen, then exchanging it for a high-yielding currency, such as the Australian dollar. The money is then invested in Australian dollars. The difference between the yield on the Australian investment and the payment on the Japanese loan is the profit.
Positive Carry and the Federal Open Market Committee
Trades involving positive carry are heavily reliant on the activities of the Federal Open Market Committee (FOMC). The federal open market committee 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 is about to embark on a policy of tightening, will remain on hold and not change interest rates, or will raise rates to slow inflation.