What is a financing 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 relative to the high-yield (asset) currency.
Investors borrow the funding currency and take short positions in the asset currency, which has a higher interest rate.
- Financing currencies, in a carry trade, refer to money in foreign currency that is borrowed to buy another currency.
- The financing currency will have a low interest rate and will be used to finance the purchase of a high-yield 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.
How a funding currency works
The Japanese yen has historically been popular as a funding currency among currency traders due to low interest rates in Japan. For example, a merchant will borrow Japanese yen and buy a currency with a higher interest rate, such as the Australian dollar or the New Zealand dollar. Other funding currencies include the Swiss franc and, in some cases, the US dollar.
In times of great optimism and rising equity prices, funding currencies will underperform because investors are willing to take more risk. On the other hand, during financial crises, investors will rush to fund currencies because they are considered safe haven assets.
For example, in the 12 months before the Great Recession, the Australian dollar and the New Zealand dollar appreciated more than 25 percent against the Japanese yen. However, since mid-2007, when the crisis began to unfold, these carry trades were undone and investors abandoned the higher-yielding currencies in favor of the funding currency. Both the Australian dollar and the New Zealand dollar lost more than 50 percent of their value against the Japanese yen during the recession.
Funding currency and interest rate policy
Central bank financing currencies like the Japanese yen have often engaged in aggressive monetary stimulus that has resulted in low interest rates. Following the bursting of an asset price bubble in the early 1990s, the Japanese economy slipped into a recession and economic malaise from which it has since struggled to emerge, due in part to the deflationary effect of a declining population. . In response, the Bank of Japan has instituted a low interest rate policy 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 to prevent the Swiss franc from appreciating too much against the euro.
Funding currencies finance the currency carry trade, one of the most popular forex strategies, 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 increase their small profit margins.
The most popular carry trades have involved buying currency pairs such as the Australian dollar / Japanese yen and the New Zealand dollar / Japanese yen because the interest rate differentials on these currency pairs have been quite high. The first step in putting together a carry trade is figuring out which currency is high-yielding and which is low-yielding.
The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the US dollar were to fall in value relative to the Japanese yen, the trader is at risk of losing money. In addition, these transactions are usually made with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is adequately hedged.
Forex tales of prudential funding
The Japanese yen (JPY) was a favored carry trade currency in the early 2000s. As the economy slipped into recession and economic malaise partly due to the deflationary effect of a declining population, the BoJ instituted a policy of reduction of interest rates. Its popularity stemmed from near-zero interest rates in Japan. As of early 2007, the yen had been used to fund an estimated $ 1 trillion worth of currency carry trades. The yen carry trade collapsed dramatically in 2008 when global financial markets collapsed, as a result of which the yen rose nearly 29% against most major currencies. This massive increase meant that it was much more expensive to pay back the borrowed funding currency and sent shockwaves through the currency carry trade market.
Another favored funding currency is the Swiss franc (CHF), which is frequently used in CHF / EUR trading. The Swiss National Bank (SNB) had kept interest rates low to prevent the Swiss franc from appreciating too much against the euro.
In September 2011, the bank broke with tradition and pegged the currency to the euro, with the rate set at 1.2000 Swiss francs per euro. He defended parity with CHF open market sales to maintain parity in the foreign exchange market. In January 2015, the SNB suddenly released the parity and rallied the currency, wreaking havoc on the equity and forex markets.
Forex carry trade example
As an example of a currency carry trade, suppose a trader notices that rates in Japan are 0.5 percent, while in the United States they are 4 percent. This means that the trader expects to make a profit of 3.5 percent, which is the difference between the two rates. The first step is to borrow yen and convert it into dollars. The second step is to invest those dollars in a security that pays the US rate. Suppose the current exchange rate is 115 yen to the dollar and the merchant borrows 50 million yen. Once converted, the amount you would have is:
- US dollars = 50 million yen ÷ 115 = $ 434,782.61
After one year invested at a rate of 4 percent in the US, the merchant has:
- Ending Balance = $ 434,782.61 x 1.04 = $ 452,173.91
Now the merchant owes 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 remains the same throughout the year and ends at 115, the amount owed in US dollars is:
- Amount owed = 50.25 million yen ÷ 115 = $ 436,956.52
The merchant benefits from the difference between the ending balance in US dollars 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 benefit more. If the yen becomes stronger, the trader will gain less than 3.5 percent or may even experience a loss.