excerpted from capital ideas
Carry Trading: Not Just for Currencies
What if there were a simple, straightforward methodology to measure an investment's expected return - in multiple types of investments?
It turns out there is. The notion of "carry," an asset's expected return assuming its price remains the same, elegantly provides that methodology, according to research by Tobias J. Moskowitz, Fama Family Professor of Finance, with Ralph S.J. Koijen of the London Business School and two other colleagues.
In finance, carry typically refers to currency trades in which money is borrowed in a currency with low interest rates and invested somewhere else that has higher rates of return. Academic research about the notion of carry is almost entirely focused on currency trades.
In their working paper, "Carry," the authors argue, however, that the concept can be applied to virtually any asset class, and provides a framework to link return predictors - such as dividend yields and bond coupons - in different asset classes. Carry can be used to predict returns in these assets classes and applying it across asset classes can improve returns.
"The simple concept [of carry] characterizes a lot of different predictors that people previously thought were disconnected," says Moskowitz.
Macro hedge funds have long utilized the currency carry trade - borrowing money in Japan, for example, and reinvesting in other countries where assets provide higher yields. But by studying carry in eight widely varying financial markets, the authors demonstrate that carry itself is an effective predictor of an asset's return.
They show that bond carry is closely related to the slope of the yield curve, for example, and equity carry is a "forward-looking measure related to dividend yields."–John Hintze
Photo by Dan Dry