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Some investing strategies require investors to take two investment positions that naturally offset each other and try to profit from the combination. Negative carry refers to a pair of offsetting positions in which the cash inflow from one of the positions is less than the cash outflow from the opposite position. Although strategies that involve investing in negative carry situations don't appear profitable up front, the question in evaluating their success is whether the cost of holding the negative carry position is worth the potential return from the paired trade.

A simple example of negative carry

To better explain the concept of negative carry, consider an example. Say that you have two positions, a $10,000 loan that you took out at 4% interest and a $10,000 municipal bond investment that you own that pays 3% interest. The two positions offset each other because they are both for $10,000.

On the loan, you'll end up owing 4% interest on $10,000, which works out to $400 per year. The municipal bond will pay 3% on $10,000, or $300 per year. That leaves you with a deficit of $100, and that's why the position is said to have negative carry.

Why would anyone ever do a negative carry trade?

At first glance, it looks like there'd be no reason to do a negative carry trade. After all, the offsetting positions cost money, and so it's unclear what the offsetting benefit might be.

As negative carry trades usually work, however, there are some situations in which it can make sense. One is when there are tax considerations to take into account. For example, in the example above, if the investors can deduct the $400 in interest but the $300 from the muni bond is tax-free, then the tax benefit exactly matches the negative carry if the taxpayer is in the 25% tax bracket. For those in higher tax brackets, the position generates a net profit after tax -- again, assuming that the taxpayer can deduct the interest on the loan.

Also, investors in the foreign exchange markets sometimes have reason to use negative carry trades. If you borrow money in a currency for which interest rates are high and then invest in assets in a different currency for which interest rates are low, you'll have a negative carry trade situation. However, if the value of the higher-yielding currency declines against the lower-yielding currency, then the profits from the favorable shift in exchange rates can more than offset the negative carry from having to borrow at higher interest rates than you can get from assets denominated in the lower-rate currency.

Negative carry situations aren't all that common as potential profit makers for investors. However, knowing what they are can help you identify them -- as well as make sure that you avoid unwittingly getting yourself into a negative carry trade.

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