Positive Carry

Overview

Positive carry occurs when an investment yields a higher return than the cost of financing it. It is often observed in fixed-income securities like bonds. When the interest earned from the investment exceeds the interest paid for borrowing the capital, the investor gains a net positive return, referred to as a positive carry.

Detailed Explanation

Positive carry is a scenario in which the earnings from an investment are greater than the costs incurred to finance that investment. This term is most commonly used in the context of bond investments but can apply to other financial instruments as well.

Example

Consider an investor who purchases a bond that yields 10% per annum. To finance this purchase, the investor takes out a loan with an interest rate of 8% per annum. Since the yield from the bond (10%) is higher than the cost of borrowing (8%), the investor achieves a positive carry:

Bond Yield: 10%
Loan Interest: 8%
Net Yield (Positive Carry): 10% - 8% = 2%

In this case, the investor earns a 2% annual profit from the difference between the bond yield and the loan interest rate.

Frequently Asked Questions (FAQs)

Q1: What is the key benefit of positive carry?

A1: The key benefit is the potential for net positive returns, enhancing profitability without requiring additional investment capital.

Q2: How does positive carry differ from negative carry?

A2: Positive carry occurs when investment yields exceed borrowing costs, while negative carry happens when borrowing costs surpass investment yields.

Q3: Can positive carry be found in investments other than bonds?

A3: Yes, positive carry can be observed in various investments where yields are higher than financing costs, such as in real estate and certain derivatives.

Q4: Is positive carry risk-free?

A4: No, positive carry involves risks, including the potential for yield changes and the cost of maintaining the borrowed capital.

Q5: How can investors measure positive carry?

A5: Investors compare the yield of the investment with the borrowing cost, ensuring that yield exceeds interest expenses.

Negative Carry: A situation where the cost to finance an investment is higher than the yield earned from the investment, resulting in a net loss.
Yield: The income return on an investment, typically expressed as an annual percentage rate.
Interest Rate: The cost of borrowing money, usually expressed as an annual percentage of the loan amount.
Fixed-Income Security: A financial instrument, like a bond, that provides regular interest payments and the return of principal at maturity.

Online References

Suggested Books for Further Studies

“Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman and Angel Serrat.
- An in-depth guide to understanding fixed-income securities, including the concepts of positive and negative carry.
“Bond Markets, Analysis, and Strategies” by Frank J. Fabozzi.
- Provides comprehensive coverage of the bond markets and key strategies involving positive and negative carry.
“Investments” by Zvi Bodie, Alex Kane, and Alan J. Marcus.
- Covers essential investment principles, including the mechanisms of yield and interest rates.

Fundamentals of Positive Carry: Finance Basics Quiz

### What is positive carry? - [x] When the cost of borrowing is lower than the yield on the investment. - [ ] When the cost of borrowing is higher than the yield on the investment. - [ ] When the yield on the investment is zero. - [ ] When the borrower's credit rating is positive. > **Explanation:** Positive carry occurs when the yield on the investment exceeds the cost of borrowing, resulting in a net positive return. ### In the context of bonds, what constitutes a positive carry scenario? - [ ] When the bond's yield is lower than the loan interest rate. - [x] When the bond's yield is higher than the loan interest rate. - [ ] When the bond principal is returned. - [ ] When the bond pays no interest. > **Explanation:** A positive carry in bond investments is achieved when the bond's yield is higher than the interest rate of the borrowed money used to purchase the bond. ### Which of the following terms is the opposite of positive carry? - [ ] Neutral carry - [x] Negative carry - [ ] Yield curve - [ ] Principal repayment > **Explanation:** Negative carry is the opposite of positive carry, occurring when the cost of financing exceeds the yield from the investment. ### How do investors benefit from a positive carry? - [ ] By avoiding all risks associated with the investment - [ ] By ensuring zero returns on investments - [x] By earning a net positive return over borrowing costs - [ ] By raising their borrowing costs > **Explanation:** Investors benefit from positive carry by earning more from the investment yield than they pay in borrowing costs, resulting in a net positive return. ### Which investment scenario is an example of positive carry? - [x] A bond yielding 7% financed by a loan with a 5% interest rate - [ ] A bond yielding 5% financed by a loan with a 7% interest rate - [ ] A bond yielding 6% with internal financing - [ ] A bond yielding 8% purchased outright without borrowing > **Explanation:** The first scenario illustrates positive carry because the bond’s yield (7%) exceeds the cost of the loan (5%), resulting in a positive return. ### What risk is associated with positive carry? - [ ] Regulatory risk - [x] Yield curve risk - [ ] No associated risk - [ ] Dividend risk > **Explanation:** Yield curve risk is associated with positive carry because fluctuations in interest rates can affect the yield and borrowing costs. ### Positive carry is considered advantageous in which financial strategy? - [ ] Buy and hold strategy - [ ] Speculative selling - [x] Carry trade strategy - [ ] Distressed asset buying > **Explanation:** Positive carry is advantageous in the carry trade strategy, which involves borrowing at low interest rates and investing in higher-yielding assets. ### What determines the amount of positive carry? - [ ] The creditworthiness of the borrower - [x] The difference between the investment’s yield and the borrowing cost - [ ] The maturity period of the loan - [ ] The rate of amortization > **Explanation:** The amount of positive carry is determined by the difference between the yield on the investment and the cost of borrowing capital. ### What is the role of interest rates in positive carry? - [ ] They determine the face value of the investment - [x] They influence the cost of borrowing money to finance the investment - [ ] They affect the risk of principal return - [ ] They evaluate the market price of bonds > **Explanation:** Interest rates play a crucial role in positive carry by determining the cost of borrowing money used to finance the investment. ### Can positive carry change over time? - [x] Yes, it can vary based on changes in yields and borrowing costs - [ ] No, it remains fixed once established - [ ] Only during extreme market conditions - [ ] Only if regulatory rules change > **Explanation:** Positive carry can change over time due to fluctuations in market yields and borrowing costs, affecting the net return.

Thank you for exploring the concept of positive carry and tackling the quiz questions to deepen your understanding of finance! Keep achieving excellence!