What Is a Funding Currency?
Investors borrow the funding currency and take short positions in the asset currency, which has a higher interest rate.
- Funding currencies, in a carry trade, refer to the money foreign currency that is borrowed to purchase another currency.
- The funding currency will have a low interest rate and is used to finance the purchase of a high-yielding 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.
Currency Carry Trade
How a Funding Currency Works
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 or 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 underperform 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 their 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 too 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 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.
The most popular carry trades have involved buying currency pairs like the Australian dollar/Japanese yen and New Zealand dollar/Japanese yen because the interest rate spreads of these currency pairs have been quite high. The first step in putting together a carry trade is to find out which currency offers a high yield and which one offers a low yield.
The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar were to fall in value relative to the Japanese yen, the trader runs the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately.
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 t0o 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 re-floated the currency, wreaking havoc on the stock and forex markets.
Currency Carry Trade Example
As an example of a currency carry trade, assume that a trader notices that rates in Japan are 0.5 percent, while they are 4 percent in the United States. This means the trader expects to profit 3.5 percent, which is the difference between the two rates. The first step is to borrow yen and convert them into dollars. The second step is to invest those dollars into a security paying the U.S. rate. Assume the current exchange rate is 115 yen per dollar and the trader borrows 50 million yen. Once converted, the amount that he would have is:
- U.S. dollars = 50 million yen ÷ 115 = $434,782.61
After a year invested at the 4 percent U.S. rate, the trader has:
- Ending balance = $434,782.61 x 1.04 = $452,173.91
Now, the trader owes the 50 million yen principal plus 0.5 percent interest for a total of:
- Amount owed = 50 million yen x 1.005 = 50.25 million yen
If the exchange rate stays the same over the course of the year and ends at 115, the amount owed in U.S. dollars is:
- Amount owed = 50.25 million yen ÷ 115 = $436,956.52
The trader profits on the difference between the ending U.S. dollar balance and the amount owed, which is:
- Profit = $452,173.91 - $436,956.52 = $15,217.39
Notice that this profit is exactly the expected amount: $15,217.39 ÷ $434,782.62 = 3.5%
If the exchange rate moves against the yen, the trader would profit more. If the yen gets stronger, the trader will earn less than 3.5 percent or may even experience a loss.