What is a Funding Currency
The funding currency is the currency that is exchanged in a currency carry trade transaction. A funding currency typically has a low interest rate. Investors borrow the funding currency and take short positions in the asset currency, which has a higher interest rate
BREAKING DOWN Funding Currency
The Japanese yen has historically been popular as a funding currency among forex traders because of low interest rates in Japan. For example, a trader will borrow Japanese yen and purchase a currency with a higher interest rate, such as the Australian dollar of New Zealand dollar. Other funding currencies include the Swiss franc, and in some cases, the U.S. dollar.
During times of high optimism and increasing equity prices, funding currencies will under perform because investors are willing to take on more risk. On the other hand, during financial crises, investors will rush to funding currencies because they are considered safe haven assets.
For example, in the 12 months before the Great Recession, the Australian dollar and New Zealand dollar appreciated by more than 25 percent against the Japanese yen. However, from mid-2007, as the crisis began to unfold, these carry trades were unwound and investors dumped the higher yielding currencies in favor of the funding currency. Both the Australian dollar and New Zealand dollar lost more than 50 percent of its value against the Japanese yen during the recession.
Funding Currencies and Interest Rate Policy
The central banks of funding currencies like the Japanese yen have often engaged in aggressive monetary stimulus which has resulted in low interest rates. Following the bursting of an asset price bubble in the early 1990s, the Japanese economy fell into a recession and economic malaise from which it has struggled since to emerge, due in part to the deflationary effect of a declining population. In response the Bank of Japan has instituted a policy of low interest rates that has lasted to this day.
The Swiss franc has also been a popular carry trade instrument, as the Swiss National Bank has been forced to keep interest rates low in order to prevent the Swiss franc from appreciating to severely against the euro.
The Currency Carry Trade
Funding currencies fund the currency carry trade, one of the most popular strategies in forex, with billions in cross border border loans outstanding. The carry trade has been likened to picking up pennies in front of a steamroller, because traders often use massive leverage to boost their small profit margins.