Cash Carry and Financing Your Investments

Cash Carry and Financing Your Investments explained by professional Forex trading experts the “ForexSQ” FX trading team.

Cash Carry and Financing Your Investments

Imagine that you know you are going to acquire shares of a company such as U.S. Bancorp or Wells Fargo. You are due for some major cash windfall such as a bonus, inheritance, or proceeds from the sale of real estate. While you are waiting for these funds, the stock market crashes and you find yourself, after careful analysis, coming to the conclusion that the stock in which you are interested is cheap; dirt cheap.

What are you to do? Wait, and hope for the same (or lower) price, taking the risk that by sitting on the sidelines you could have missed the opportunity to buy at an attractive price?

Not necessarily. In professional investing, there is a concept known as cash carry. It is the cash flow requirements necessary to support a particular debt or obligation. Cash carry essentially makes it easier to use your margin purchasing power to finance the acquisition of those shares without introducing a large amount of risk. There are typically three important ingredients to making the concept of cash carry work for you. Let’s examine each.

1. To Take Advantage of Cash Carry, You Must Have Other Investments or Assets Against Which You Can Borrow

Let me say again, as I have many times on the site, that ordinarily, margin debt is extremely risky for average investors because it can cause small changes in market prices to wipeout all of their equity, leaving them broke and, in some cases, forced to declare bankruptcy because they can’t meet their obligation to the brokerage house.

Here’s an example why: Imagine you have $50,000 in your brokerage account, all of which is invested in blue chip stocks. All else being equal, you could borrow a maximum of $50,000 against these securities so that in the end, you had $100,000 of stocks and a $50,000 margin debt against them payable at a rate of interest to be determined by your brokerage firm or financial institution.

You would never want to press your maximum purchasing power because in the event of a correction, your stocks might fall 10%. On a $100,000 portfolio, that is $20,000 – or 20% of your equity of $50,000 thanks (or no thanks, in this case) to the 2-1 leverage employed. That means that your equity would fall to $30,000 while your margin debt remained $50,000. It is very possible you would get a call from your broker telling you to deposit additional funds immediately or they will sell the stocks in your account to pay off as much of their debt as possible. In many cases, this can trigger capital gains taxes as well, making a bad situation even worse. That brings us to our second point.

2. Leave an Ample Margin of Safety So You Won’t Be Subject to a Margin Call Even if a 1987-Type Crash Happens With No Warning

A general rule of thumb, which may still be too aggressive for the average investor, is the 2/3rds rule. Basically, take your equity balance, in this case $50,000, and divide it by .67 – in our example, the result is $74,626. Now, take that amount and subtract your equity balance ($50,000) and end up with $24,626. This is the maximum amount you could borrow assuming stock prices are reasonable and you don’t expect any major financial shocks.

Another acceptable metric is the more conservative 3/4ths rule whereby you simply substitute .75 for the .67 variable in the formula. In this case, you would end up with just shy of $16,700. Only you and your financial advisor can determine what is the most prudent course of action based upon your specific objectives and circumstances.

3. The Stock (or Other Asset) Should Generate Large Amounts of Cash Relative to Cost

In the case of common stocks, you would want a nice, secure, fat, dividend yield. Using our example of U.S. Bank, you could buy $24,626 of the stock on margin against your $50,000 equity balance. The stock yields around 4.5%, or approximately $1,108 in the first year. If your margin debt rate were 8.5%, your first year interest expense would be roughly $2,100. Had the stock not paid any dividends, this whole amount would have been added onto your margin debt bringing it to $26,726 within twelve months of the purchase.

Yet, along the way, those dividends would show up, reducing the cost to carry the debt. In this case, the total cost would be nearly cut in half, resulting in an increase in margin debt to only $25,618 in comparison. This adds to the margin of safety and if you are able to at least deposit the difference of $992, your margin balance would remain $24,626 – the cost of the shares. In the meantime, over a few years, the value of those shares should (you hope) rise and you will receive your windfall in the meantime, allowing you to pay off the balance.

Caution! This is Not an Appropriate Technique for Most Investors!

Unless you are financially secure, able to meet potential margin calls, have a considerable margin of safety in the form of an equity balance as a percentage of total margin debt, and are absolutely convinced based upon a conservative and professional-level analysis of a company’s SEC filings and other documents that you’ve found a stock or asset that may be undervalued, and you expect a cash windfall to pay off the total balance, this technique is probably very inappropriate for you. Do not attempt it unless you meet this description and a qualified, well-regarded money manager with whom you work believes it is appropriate for you.