What it is:
Foreign-exchange risk refers to the potential for loss from exposure to foreign exchange rate fluctuations.
How it works (Example):
Foreign-exchange risk is the risk that an asset or investment denominated in a foreign currency will lose value as a result of unfavorable exchange rate fluctuations between the investment's foreign currency and the investment holder's domestic currency.
Holders of foreign bonds face foreign-exchange risk, because 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 10% coupon rate in Canadian dollars (CAD). If the exchange rate at the time of purchase is $1 CAD: $1 USD, then the 10% coupon payment is equal to $100 Canadian, and because of the exchange rate, it is also equal to US$100.
Now let's assume a year from now the exchange rate is 1:0.85. Now the bond's 10% coupon payment, which is still $100 Canadian, is worth only US$85. 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 it Matters:
Foreign-exchange risk is an additional dimension of risk which offshore investors must accept. As a result, open positions in non-dollar-denominated items may need to be closed. Though foreign-exchange risk specifically addresses undesirable movements that might result in losses, it is possible to benefit from favorable fluctuations with the potential for additional value above and beyond that of an already-stable investment.