FX Carry Trade
Traditionally the idea of carry trade started in foreign exchange trading. In currency trading you always sell a currency to buy another currency. For example if you buy Australian dollar
- You buy AUD and;
- sell it against another currency such as the USD, Yen or Euro to convert it from.
- The net position is long one currency and short another.
Back when interest rates weren’t zero there was always an interest rate differential between two currencies and the carry is earned on buy high yield / sell low yielding currencies.
What is Positive Carry?
A positive carry is when the interest you earn on the long currency is higher than the interest rate you pay to borrow on the currency you shorted against.
From the example above if the Australian interest rate was 5% and you shorted the Yen which you borrowed and paid 3% interest. You have a 2% positive carry.
Positive carry trades were really popular pre-GFC as it was during a period of relative stable economic environment coupled with existence of interest differentials especially between developed markets and emerging markets.
Carry Trade Examples Today
Today the idea of carry trade has extended across finance. The idea of buying a high yielding asset and earn the difference between the borrowing cost and asset return is not new. These kind of trades are now known as carry trades:
- Banks lend for the long term while borrowing short and sometimes to their detriment as seen during the GFC. Banks were long mortgages while funding the loans with short term commercial paper.
- Using margin loans by buying high yield shares with dividend yields higher than than the cost of the loan.
- Borrowing and buy real estate investment with higher rental yield.
Negative Carry Trade
Negative carry is when the cost of holding the position outweigh the benefits. The only reason you would hold a negative cost of carry investment is anticipating that the value of the asset is appreciating and the gains from sale will outweigh all of the losses to date.
- Negative gearing is an example of negative carry investment where the hold cost during the term of the investment outweighs the income.
- Negative carry FX similar to above is when there is a cost of holding the FX position usually because the currency gain will cover the interest cost