What is Currency Risk?
Currency risk, also called foreign-exchange risk or exchange-rate risk, is the risk that changes in the relative value of certain currencies will reduce the value of investments denominated in a foreign currency.
How Does Currency Risk Work?
Currency risk may be the single biggest risk for holders of bonds that make interest and principal payments in a foreign currency. For example, assume XYZ Company is a Canadian company and pays interest and principal on a $1,000 bond with a 5% coupon in Canadian dollars. If the exchange rate at the time of purchase is 1:1, then the 5% coupon payment is equal to $50 Canadian, and because of the exchange rate, it is also equal to $50 U.S.
Now let's assume a year from now the exchange rate is 1:0.85. Now the bond's 5% coupon payment, which is still $50 Canadian, is worth only $42.50 U.S. The investor has lost a portion of his return for reasons that had nothing to do with the issuer's ability to pay.
Why Does Currency Risk Matter?
Currency risk matters because exchange rates affect the amount of money the investor actually sees at the end of the day, and this in turn determines what the investor's rate of return ultimately is.
However, currency risk can create opportunities because the interest rates between two countries often reflect expected changes in the exchange rate between them. For example, if interest rates are higher in Canada, the U.S. dollar probably will decline in value relative to the Canadian dollar. (This is because when interest rates increase in a particular country, international money flows into that country to capture the higher yields. This pushes the value of that country's currency higher.) Currency risk also means that investors in foreign bonds can indirectly participate in the foreign-exchange markets.
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