Carry (investment)
Encyclopedia
The carry of an asset
is the return
obtained from holding it (if positive), or the cost
of holding it (if negative) (see also Cost of carry
).
For instance, commodities are usually negative carry assets, as they incur storage costs or may suffer from depreciation, but in some circumstances, appropriately hedged commodities can be positive carry assets if the forward/futures market is willing to pay sufficient premium for future delivery.
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; such as gold during financial crisis, due to its safe haven
quality.
Carry trades are not arbitrage
s: pure arbitrages make money no matter what; carry trades make money only if nothing changes against the carry's favor.
s 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, which is usually higher than the short-term rate).
This works with an upward-sloping yield curve
, but it loses money if the curve becomes inverted. Many investment banks, such as Bear Stearns
, have failed because they borrowed cheap short-term money to fund higher interest bearing long-term positions. When the long-term positions default, or the short-term interest rate rises too high (or there are simply no lenders), the bank cannot meet its short-term liabilities and goes under.
According to a popular anecdote, traditional commercial banking was 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. While this may have been close to the truth in the market of the 1950s to the 1970s, the modern competitive market ensures that profits are kept more in line with perceived risks.
.
The term carry trade without further modification refers to currency carry trade: investors borrow low-yielding currencies
and lend (invest in) high-yielding currencies. It is thought to correlate with global financial and exchange rate
stability and retracts in use during global liquidity shortages, but the carry trade is often blamed for rapid currency value collapse and appreciation.
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. 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 currency that is borrowed, because investors sell the borrowed money by converting it to other currencies.
By early year 2007, it was estimated that some US$1 trillion may have been staked on the yen
carry trade. Since the mid-90'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. These activities include subprime lending
in the USA, and funding of emerging markets, especially BRIC
countries and resource rich countries. The trade largely collapsed in 2008 particularly in regards to the yen
.
The US dollar and the yen have been the currencies most heavily used in carry trade transactions since the 1990s. There is some substantial mathematical evidence in macroeconomics that larger economies have more immunity to the disruptive aspects of the carry trade mainly due to the sheer quantity of their existing currency compared to the limited amount used for FOREX carry trades, but the collapse of the carry trade in 2008 is often blamed within Japan for a rapid appreciation of the yen
. As a currency appreciates there is pressure to cover any debts in that currency by converting foreign assets into that currency, so this can be an accelerating effect in currency valuation changes. When a large swing occurs, this can cause a carry reversal. The timing of the carry reversal in 2008 contributed substantially to the credit crunch
which caused the 2008 global financial crisis. Though, relative size of impact of the carry trade with other factors is debatable. A similar rapid appreciation of the US dollar occurred at the same time, and the carry trade is rarely discussed as a factor for this appreciation.
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
is the return
Returns (economics)
Returns, in economics and political economy, are the distributions or payments awarded to the various suppliers of the factors of production.-Wages:...
obtained from holding it (if positive), or the cost
Cost
In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this...
of holding it (if negative) (see also Cost of carry
Cost of carry
The cost of carry is the cost of "carrying" or holding a position. If long, the cost of carry is the cost of interest paid on a margin account. Conversely, if short, the cost of carry is the cost of paying dividends, or rather the opportunity cost; the cost of purchasing a particular security...
).
For instance, commodities are usually negative carry assets, as they incur storage costs or may suffer from depreciation, but in some circumstances, appropriately hedged commodities can be positive carry assets if the forward/futures market is willing to pay sufficient premium for future delivery.
This can also refer to a trade with more than one leg, where you earn the spread
Spread
Spread may refer to:*Statistical dispersion*Spread , an edible paste put on other foods*the score difference being wagered on in spread betting*the measure of line inclination in rational trigonometry...
between borrowing a low carry asset and lending a high carry one; such as gold during financial crisis, due to its safe haven
Safe haven
Safe haven may refer to:* Safe harbor, a harbor or haven which provides safety from weather or attack, or an analogous situation* Safe Havens, a syndicated comic strip drawn by cartoonist Bill Holbrook...
quality.
Carry trades are not arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
s: pure arbitrages make money no matter what; carry trades make money only if nothing changes against the carry's favor.
Interest rates carry trade / Maturity Transformation
For instance, the traditional income stream from commercial bankBank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s is to borrow cheap (at the low overnight rate
Overnight rate
The overnight rate is generally the rate that large banks use to borrow and lend from one another on the overnight market. In some countries , the overnight rate may be the rate targeted by the central bank to influence monetary policy...
, i.e., the rate at which they pay depositors) and lend expensive (at the long-term rate, which is usually higher than the short-term rate).
This works with an upward-sloping yield curve
Yield curve
In finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
, but it loses money if the curve becomes inverted. Many investment banks, such as Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
, have failed because they borrowed cheap short-term money to fund higher interest bearing long-term positions. When the long-term positions default, or the short-term interest rate rises too high (or there are simply no lenders), the bank cannot meet its short-term liabilities and goes under.
According to a popular anecdote, traditional commercial banking was 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. While this may have been close to the truth in the market of the 1950s to the 1970s, the modern competitive market ensures that profits are kept more in line with perceived risks.
Currency
The currency carry trade is an uncovered interest arbitrageUncovered interest arbitrage
Uncovered interest arbitrage is a form of arbitrage where funds are transferred abroad to take advantage of higher interest in foreign monetary centers. It involves the conversion of the domestic currency to the foreign currency to make investment; and subsequent re-conversion of the fund from the...
.
The term carry trade without further modification refers to currency carry trade: investors borrow low-yielding currencies
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
and lend (invest in) high-yielding currencies. It is thought to correlate with global financial and exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
stability and retracts in use during global liquidity shortages, but the carry trade is often blamed for rapid currency value collapse and appreciation.
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. In theory, according to uncovered interest rate parity, carry trades should not yield a predictable profit
Profit (economics)
In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs of a venture to an entrepreneur or investor, whilst economic profit In economics, the term profit has two related but distinct meanings. Normal profit represents the total...
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 currency that is borrowed, because investors sell the borrowed money by converting it to other currencies.
By early year 2007, it was estimated that some US$1 trillion may have been staked on the yen
Japanese yen
The is the official currency of Japan. It is the third most traded currency in the foreign exchange market after the United States dollar and the euro. It is also widely used as a reserve currency after the U.S. dollar, the euro and the pound sterling...
carry trade. Since the mid-90's, the Bank of Japan
Bank of Japan
is the central bank of Japan. The Bank is often called for short. It has its headquarters in Chuo, Tokyo.-History:Like most modern Japanese institutions, the Bank of Japan was founded after the Meiji Restoration...
has set Japanese interest rates at very low levels making it profitable to borrow Japanese yen to fund activities in other currencies. These activities include subprime lending
Subprime lending
In finance, subprime lending means making loans to people who may have difficulty maintaining the repayment schedule...
in the USA, and funding of emerging markets, especially BRIC
BRIC
In economics, BRIC is a grouping acronym that refers to the countries of Brazil, Russia, India and China, which are all deemed to be at a similar stage of newly advanced economic development...
countries and resource rich countries. The trade largely collapsed in 2008 particularly in regards to the yen
Japanese yen
The is the official currency of Japan. It is the third most traded currency in the foreign exchange market after the United States dollar and the euro. It is also widely used as a reserve currency after the U.S. dollar, the euro and the pound sterling...
.
Known risks
The 2008–2011 Icelandic financial crisis has among its origins the undisciplined use of the carry trade. Particular attention has been focused on the use of Euro denominated loans to purchase homes and other assets within Iceland. Most of these loans defaulted when the relative value of the Euro appreciated dramatically causing loan payment to be unaffordable.The US dollar and the yen have been the currencies most heavily used in carry trade transactions since the 1990s. There is some substantial mathematical evidence in macroeconomics that larger economies have more immunity to the disruptive aspects of the carry trade mainly due to the sheer quantity of their existing currency compared to the limited amount used for FOREX carry trades, but the collapse of the carry trade in 2008 is often blamed within Japan for a rapid appreciation of the yen
Endaka
Endaka or Endaka Fukyo is a state in which the value of the Japanese yen is high compared to other currencies. Since the Economy of Japan is highly dependent on exports, this can cause Japan to fall into an economic recession....
. As a currency appreciates there is pressure to cover any debts in that currency by converting foreign assets into that currency, so this can be an accelerating effect in currency valuation changes. When a large swing occurs, this can cause a carry reversal. The timing of the carry reversal in 2008 contributed substantially to the credit crunch
Credit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...
which caused the 2008 global financial crisis. Though, relative size of impact of the carry trade with other factors is debatable. A similar rapid appreciation of the US dollar occurred at the same time, and the carry trade is rarely discussed as a factor for this appreciation.
See also
- Convenience yieldConvenience yieldA convenience yield is an adjustment to the cost of carry in the non-arbitrage pricing formula for forward prices in markets with trading constraints....
- Carrying chargeCarrying chargeA carrying charge is the cost of storing a physical commodity, such as grain or metals, over a period of time. The carrying charge includes insurance, storage and interest on the invested funds as well as other incidental costs. In interest rate futures markets, it refers to the differential...
- Cost of carryCost of carryThe cost of carry is the cost of "carrying" or holding a position. If long, the cost of carry is the cost of interest paid on a margin account. Conversely, if short, the cost of carry is the cost of paying dividends, or rather the opportunity cost; the cost of purchasing a particular security...
- Demurrage (currency)Demurrage (currency)Demurrage is a cost associated with owning or holding currency over a given period of time. It is sometimes referred to as a carrying cost of money. For commodity money such as gold, demurrage is in practice nothing more than the cost of storing and securing the gold...
- Interest rate parityInterest rate parityInterest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic...
- Covered interest arbitrageCovered interest arbitrageCovered interest arbitrage is the investment strategy where an investor buys a financial instrument denominated in a foreign currency, and hedges his foreign exchange risk by selling a forward contract in the amount of the proceeds of the investment back into his base currency...
- Spot-future paritySpot-future paritySpot-future parity is a parity condition that should theoretically hold, or opportunities for arbitrage exist. Spot-future parity is an application of the law of one price...
- EndakaEndakaEndaka or Endaka Fukyo is a state in which the value of the Japanese yen is high compared to other currencies. Since the Economy of Japan is highly dependent on exports, this can cause Japan to fall into an economic recession....
External links
- The Yen Carry Trade Revisited
- The Unwinding of the Carry Trade Has Finally Hit Currencies by Jeffrey Frankel, Harvard Kennedy School, Oct. 29, 2008
- The Effects of the Yen Carry Trade Unwinding
- "GETTING TECHNICAL: A Secret Time Bomb Made of Gold"
- An explanation of the carry trade
- Mother of all carry trades faces an inevitable bust by Nouriel RoubiniNouriel RoubiniNouriel Roubini is an American economist. He claims to have predicted both the collapse of the United States housing market and the worldwide recession which started in 2008. He teaches at New York University's Stern School of Business and is the chairman of Roubini Global Economics, an economic...
, 1 Nov 2009 - Carry Trades and Speculative Dynamics by Guillaume Plantin and Hyun Song Shin, May 2010. Explains the dynamics of the carry trade by the example of Iceland and then goes on to develop a mathematical model for the exchange rate movements caused by carry trades.