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Many investors use investing strategies that involve holding two offsetting positions in a particular investment. If the cash inflow from one of the positions is greater than the cash outflow from the opposite position, then the overall strategy is said to have positive carry. Strategies that produce positive carry can be extremely profitable, but they come with some risks that investors often don't expect.

A simple example of positive carry

To understand the concept of positive carry, consider this simple example. Say you have an opportunity to get a credit card with a 0% interest rate for a year. You have plans to make a $10,000 purchase toward a summer vacation, and you would ordinarily pay cash for the cost. Instead, you use the credit card for the purchase and then invest $10,000 of your own cash in a one-year bank CD paying 1%. At the end of the year, you cash in the CD, use $10,000 of that cash to pay off the credit card bill, and keep the remainder.

This is a positive carry position. The CD produced interest of 1% of $10,000, or $100. Meanwhile, you didn't have to pay any interest on the credit card balance because of the introductory offer, so your cash outflow was $0. All in all, you ended up with a $100 profit. Most importantly, there was never any risk involved, because the bank CD was insured and had a guaranteed return.

Why positive carry is usually more complicated

In real life, opportunities like this are relatively rare. More common are situations in which a position will likely have positive carry, but something could go wrong, leading to losses.

For instance, investors in the foreign exchange markets have commonly used a strategy known as the "carry trade," in which they borrow money in a low-yielding currency, such as the Japanese yen or euro. They then exchange that currency for a higher-yielding currency, such as the Australian dollar, and then invest in income-producing assets denominated in that second currency. The idea is that the interest paid on the loan is less than the income they expect from the assets they invest in, producing positive carry.

The problem is that over the course of this strategy, foreign exchange rates can shift. If the lower-yielding currency weakens, then you get an added windfall from the strategy, because in the end you can convert back to the lower-yielding currency at a more favorable rate. However, if the lower-yielding currency strengthens, then it can eat into your positive carry. If it rises high enough, then you can end up with a loss on the position as a whole.

Positive carry opportunities are always attractive when they arise, but in the financial markets, there's rarely such a thing as a free lunch. Be sure you understand the risks involved whenever you see what appears to be a chance to cash in on positive carry.

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