Friction and/or imbalances in supply and demand of ‘funding’ can lead to distortions in FX forward markets which can be utilised to enhance yields on foreign assets. Typically, FX forwards can be thought of as an arbitrage-free forward price calculated from interest rate differentials between the domestic and foreign currency. However, actual forward prices in the market often differ from those implied purely based on interest rate differentials.

The difference is driven by supply and demand imbalances in funding markets, and is represented by cross-currency basis. Cross-currency basis is effectively a measure of the richness/cheapness of funding in one currency vs another.

The example of an Australian bank looking to fund its AUD denominated balance sheet can be used to illustrate the dynamic. In a simple example, the banks have two alternatives to fund their large AUD balance sheet:

1. Borrow money domestically (ie borrow AUD from AUD investors); or
2. Borrow money offshore (ie borrow non-AUD from non-AUD investors and convert the foreign currency back into AUD).

Option 1 has no direct impact on FX markets. Option 2, however, requires that the bank convert the non-AUD borrowed funds back into AUD (to finance their current assets) and hedge the FX exposure arising from the non-AUD denominated loan, as illustrated in Figure 1 below.

Table 1: FX flows from Australian bank borrowing in USD

The Australian bank in the illustration above effectively enters an AUDUSD FX swap where it buys AUDUSD spot and sells AUDUSD forward. In practice, Australian banks are doing a similar thing in very large size, leading to a supply/demand imbalance where there is excess demand for spot AUD and excess supply of forward AUD. Put another way, “Banks need AUD now, which they will repay in the future”, which in turn looks a lot like AUD borrowing.

This is where the concept of “funding via FX markets” comes from. The more Aussie banks want/need to fund via FX markets, the higher the cost of funding via FX markets (excess demand increases price). The higher the cost of funding via FX markets, the higher the return to an investor willing to lend in FX markets. Hence, investors can earn excess returns by lending into FX markets where demand for FX funding exceeds supply.

What does it mean in practice to “lend” AUD in FX markets? Well, since borrowing is buying AUD spot and selling AUD forward, lending is the opposite, namely selling AUD spot and buying AUD forward. Since AUDxxx spot price and AUDxxx forward price are different (interest rate differential plus cross-currency basis), investors earn (or pay) an FX yield.

Because we’re talking FX markets, there’s always a foreign currency on the other side of that, so the investor/lender would also be buying a foreign currency spot and selling a foreign currency forward. As a result, the investor/lender holds foreign currency which they would need to deposit/invest, and the return they generate on the foreign currency denominated asset is added to the FX yield to get a total return in AUD. Figure 2 below illustrates.

Figure 2: Flow diagram for Australian investor lending in the AUDJPY FX market and earning a return on a JPY denominated asset

Let’s look at a practical example. The illustration above using AUDJPY was chosen intentionally, because that’s one market we perceive there to be an opportunity currently. A 1y JTDB (Japanese T-bills) yields -0.08%. At face value, the negative yield looks unattractive. However, that doesn’t take into account the extra yield an Australian investor can earn by lending AUD (against JPY) in the FX market. Current spot AUDJPY is 83.07, vs forward AUDJPY settling on 20Feb2023 (the same date as the 1y JTDB) at 82.31. This implies an FX yield of 0.95%. Hence, an AUD investor can earn an all-in yield of 0.87% in AUD terms on a 1y JTDB. That compares quite favourably to a 1y ACGB (0.54% for ACGB Apr23s) and even AUD swaps (0.59%). For an investor who doesn’t want to take any interest rate risk, the ‘fixed’ 0.87% can be swapped to floating 3M BBSW + 28bp.

We can do the same calculation as above for all outstanding JTDBs. The pickup over ACGBs and swap exists across the curve, with slightly better pickups available for longer maturities, as can be seen in the charts below.

Figure 3: Comparison of JTDB hedged into AUD against ACGB and AUD swap

Important Notice

Financial services provided by Challenger Investment Solutions Management Pty Ltd (ABN 63 130 035 353 AFSL 487354) (CIP Asset Management, CIPAM). The material in this document is general background information about Challenger’s Investment Solutions activities and is current at the date of this document. It is information given in summary form and does not purport to be complete. It is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any particular investor. These individual circumstances should be considered with professional advice when deciding if an investment is appropriate. Nothing in this document should be considered a solicitation, offer or invitation to buy, subscribe or sell any, or a recommendation of, financial products. All reasonable care has been taken to ensure that the facts stated and opinions given in this document are fair and accurate. To the maximum extent permitted by law, the recipient releases each member of the Challenger Limited group of companies, their directors, officers, employees, representatives and advisers from any liability (including, without limitation, in respect of direct, indirect or consequential loss or damage or loss or damage arising by negligence) arising in relation to any recipient relying on anything contained in or omitted from this document. Any forward looking statements included in this presentation involve subjective judgement and analysis and are subject to significant uncertainties, risks and contingencies, many of which are outside the control of, and are unknown to, Challenger. In particular, they speak only as of the date of these materials, and they are subject to significant regulatory, business, competitive and economic uncertainties and risks. Actual future events may vary materially from forward looking statements and assumptions on which those statements are based. Given these uncertainties, recipients are cautioned not to place undue reliance on such forward looking statements. Any past performance information provided in this presentation is not a reliable indication of future performance.This document is not audited.