What is Currency Risk?
How Does Currency Risk Work?
Currency risk is sometimes referred to as exchange-rate risk.
Holders of foreign bonds face currency risk, as those types of bonds make interest and principal payments in a foreign currency. For example, let's 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 US$50. 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 US$42.50. Despite the issuer's ability to pay, the investor has lost a portion of his return because of the fluctuation of the exchange rate.
Why Does Currency Risk Matter?
Currency risk is important to understand because foreign currency exchange rates can drastically change an investor's total return on a foreign investment, despite how well the investment performed.
Currency risk can also create an opportunity for investors when the interest rates between two countries reflect the expected changes in their exchange rates. For example, if interest rates are higher in Canada, the U.S. dollar will probably drop in value relative to the Canadian dollar. (This is because when interest rates increase in a particular country, international currencies flow into that country to take advantage of the higher yields. This pushes the value of that country's currency higher.) Currency risk also means that foreign bond investors can increase their exposure to foreign-exchange markets.