Exchange rate or currency risk, Financial Management

A bond whose payments are made in foreign currency has unknown cash flows in domestic currency. This is because the cash flows are dependent on the exchange rate prevalent at the time the payments are received from the issuer. This amounts to currency or exchange rate risk because it is the risk that arises from the change in price of one currency against the other.

For example, an investor's domestic currency is the US dollar and he purchases a bond whose payments are in Indian rupees. If the rupee depreciates relative to the US dollar at the time a payment is made, fewer US dollars can be exchanged.

Consider an investor in Japan. His domestic currency is the yen. If he purchases a US dollar denominated bond, then he is concerned that the US dollar will depreciate relative to the Japanese Yen at the time the issuer makes a payment. If the dollar does depreciate, then he will receive fewer yen in the foreign exchange market.

Thus, the risk of receiving less domestic currency on bond investment where it makes payments in a currency other than the investor's domestic currency is called exchange rate risk or currency risk.

Posted Date: 9/10/2012 1:28:00 AM | Location : United States

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