The c
ost 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 opportunity cost the cost of purchasing a particular security rather than an alternative. For most investments, the cost of carry generally refers to the risk-free interest rate that could be earned by investing currency in a theoretically safe investment vehicle such as a money market account minus any future cash-flows that are expected from holding an equivalent instrument with the same risk (generally expressed in percentage terms and called the convenience yield). Storage costs (generally expressed as a percentage of the spot price) should be added to the cost of carry for physical commodities such as corn, wheat, or gold.
The cost of carry model expresses the forward price (or, as an approximation, the futures price) as a function of the spot price and the cost of carry.
where F is the forward price, S is the spot price, e is the base of the natural logarithms, r is the risk-free interest rate, s is the storage cost, c is the convenience yield, and t is the time to delivery of the forward contract (expressed as a fraction of 1 year).
The same model in currency markets is known as interest rate parity.
For example, a US investor buying a Standard and Poor's 500 e-mini futures contract on the Chicago Mercantile Exchange could expect the cost of carry to be the prevailing risk-free interest rate (around 5% as of November, 2007) minus the expected dividends that one could earn from buying each of the stocks in the S&P 500 and receiving any dividends that they might pay, since the e-mini futures contract is a proxy for the underlying stocks in the S&P 500. Since the contract is a futures contract and settles at some forward date, the actual values of the dividends may not yet be known so the cost of carry must be estimated.Carry (investment)
Carry(Investment)
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, 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: pure arbitrages make money no matter what; carry trades make money only if nothing changes -- but things may change.
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, which is usually higher than the short-term rate).
This works in an upward-sloping yield curve, but it loses money if the curve becomes inverted. The floating of short-term rates, for example, when Paul Volcker was the chairman of the Federal Reserve resulted in exactly this problem and was the root of the Savings and Loan crisis.
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 and lend high-yielding currencies. It tends to correlate with global financial and exchange rate stability, and retracts in use during global liquidity shortages.
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 sum and convert it to other currencies.
By early year 2007, it was estimated that some US$1 trillion may be staked on the yen carry trade. Since the late-1980'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.
According to Gary Dorsch of Global Money Trends, the yen carry is a "weapon of mass destruction" of $5.9 trillion, with yen loans another 1.2 trillion dollars on top of it, making Arabian oil wealth or Chinese reserves look small at $1.5 trillion and $1.9 trillion respectively.
