What it is:
How it works (Example):
Exchange-rate 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 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. The investor has lost a portion of his return for reasons that had nothing to do with the issuer's ability to pay.
Why it Matters:
Exchange-rate 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, exchange-rate 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 will probably 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.) Exchange-rate risk also means that investors in foreign bonds can indirectly participate in the foreign-exchange markets.