What Are Funding Currencies?
Foreign exchange (forex) traders will borrow a currency that has a low-interest rate to use it as a funding currency in a carry trade. These traders hope to profit from the spread or carry trade between the low-interest money and a higher-yielding asset purchased with the funding currency. Often the trader will buy assets such as stocks, bonds, commodities, currencies, and other high-yield products with the lower-yielding currency.
This trading strategy is risky and one which only those traders with pockets deep enough to experience significant loss should attempt.
- Funding currencies are used in currency carry trades to exchange against the asset currency.
- A currency carry trade is a strategy that attempts to capture the difference between the interest rates of two currencies, which can often be substantial, depending on the amount of leverage used.
- The funding currency will have a low interest rate and is used to finance the purchase of a high-yielding asset currency.
- While carry trades are popular, they can sometimes go wrong and produce losses.
Understanding Funding Currencies
Funding currencies fund the currency carry trade, one of the most popular strategies in forex, with billions in cross-border loans outstanding. The carry trade is said to be like picking up pennies in front of a steamroller because traders often use massive leverage to boost their small profit margins. Any world currency can become a funding currency. The U.S. dollar (USD), euro (EUR), Japanese yen (JPY), and the Swiss Franc (CHF) have all been funding currencies.
The central banks of funding currency countries such as the Bank of Japan (BoJ) and the U.S. Federal Reserve often engaged in aggressive monetary stimulus which results in low-interest rates. These banks will use fiscal policy to lower interest rates to kickstart growth during a time of recession. As the rates drop, speculators borrow the money and hope to unwind their short positions before the rates increase.
Using funding currencies to make carry trades is a practice full of risks. Apart from the risk of a drastic decline in the price of the funded asset, the speculation trade also carries the risk of a steep appreciation in the funding currency if it is not the speculator's home currency.
Speculators with deep pockets will borrow the low-interest rate currency and convert that money into one which offers a higher rate of interest. Most often the trade does not involve a forex hedge. Foreign currency options are one of the most popular methods of currency hedging. As with options on other types of securities, foreign currency options give the purchaser the right, but not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in the future. Sometimes the trade works, and the trader sees a profit, but other times the trader stays short too long and changes in interest rates have them flattened by the steamroller.
Cautionary Funding Currency Tales
The Japanese Yen (JPY) is a favored carry trade currency in the early 2000s. As the economy fell into recession and economic malaise in part to the deflationary effect of a declining population, the BoJ instituted a policy of lowering interest rates. Its popularity came from the near-zero interest rates in Japan. By early 2007, the Yen had been used to fund an estimated US$1 trillion in FX carry trades. The yen carry trade unraveled spectacularly in 2008 as global financial markets crashed, as a result of which the yen surged nearly 29% against most major currencies. This massive increase meant it was much more costly to pay back the borrowed funding currency and sent shock waves through the currency carry trade market.
Another favored funding currency is the Swiss franc (CHF) frequently used in the CHF/EUR trade. The Swiss National Bank (SNB) had kept interest rates low to prevent the Swiss franc from appreciating too severely against the euro. In September 2011, the bank broke with tradition and pegged the currency to the euro, with the fix set at 1.2000 Swiss francs per euro. It defended the peg with open market sales of the CHF to maintain the peg on the forex market. In January 2015, the SNB suddenly dropped the peg and refloated the currency, wreaking havoc on the stock and forex markets.