This term refers to the practice where banks invest in one currency and fund in another through foreign exchange (F.X.) swaps. This strategy is often employed by banks to take advantage of differences in interest rates between two currencies. For instance, a bank might invest in a currency with a high interest rate while funding in a currency with a lower interest rate. This allows the bank to earn a profit from the interest rate differential. The European and Japanese banking systems have been known to engage in cross-currency funding extensively since 2000, taking on significant net on-balance-sheet positions in foreign currencies, particularly in U.S. dollars.

Choice B is incorrect. A funding gap refers to the difference between a company’s available capital and the amount required to carry out its operations or projects. It does not specifically involve investing in one currency and funding in another via foreign exchange (F.X.) swaps.

Choice C is incorrect. Carry trading is a strategy that involves borrowing at a low interest rate and investing in an asset that provides higher returns. While it can involve different currencies, it doesn’t necessarily imply using F.X. swaps for investment and funding purposes as described in the question.

Choice D is incorrect. Hedging refers to making an investment to reduce the risk of adverse price movements in an asset, typically by taking an offsetting position in a related security, such as options or futures contracts. It does not directly relate to the strategy of investing in one currency and funding another through F.X. swaps.

Things to Remember

• Foreign Exchange (F.X.) swaps involve the exchange of one currency for another at an agreed-upon exchange rate with an obligation to reverse the transaction at a future date.
• Interest rate differentials between currencies play a crucial role in determining the profitability of cross-currency funding strategies.