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Investors use a funding currency with low interest rates to purchase assets that generate additional returns, such as forex, stocks, bonds, and commodities. The strategy has low potential for failure, but choosing the right currency is important to avoid unanticipated appreciation. The Japanese yen was once the funding currency of choice, but its appreciation during the recession reminded investors of the risks involved.
The funding currency is any national currency that currently has a very low interest rate and can be used to purchase a wide range of assets that are capable of generating additional returns. Using this approach allows the investor to take advantage of any type of spread that may exist between that currency and the asset purchased. When the best effect is achieved, the investor can enjoy benefits that would not have been possible if a higher interest rate currency had been used for the buying activity.
The use of one funding currency to buy different types of investments is very common. One strategy calls for the use of a currency with a low interest rate as part of a forex or forex investment. With this scenario, the investor uses the currency with the low interest rate to buy currency that has a higher interest rate. Assuming that exchange rates move in the direction projected by that investor, he or she can generate a sizeable return using this method.
Other types of assets can also be purchased using a funding currency. The approach can be used to purchase various stocks, bonds, and commodities. As the value of those investments rises, this only serves to increase the assured rate of return when making purchases in a low interest rate currency.
One of the most attractive features of using the funding currency to buy investments is that the strategy has a relatively low potential for failure. The main potential risk has to do with an unanticipated appreciation of that currency, which will tend to minimize the spread involved and diminish the benefits for the investor. For this reason, choosing the right currency for your funding effort is extremely important, not only in terms of the current interest rate associated with that funding currency, but also what is likely to happen to rates in the future.
For most of the first decade of the 21st century, the Japanese yen was often considered the funding currency of choice, due to the consistently low interest rates associated with the currency. As the global economy entered a period of recession, the yen began to appreciate relative to other national currencies, which in turn made it less attractive to use as a funding currency. The change in the funding currency during that recession served to remind many investors that while identifying a currency with a low interest rate and using it to purchase investments is a viable plan, there will always be some degree of risk involved, so that it is important to always project future moves before executing a deal.
Smart Asset.
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