Exchange Rate Risk in Bonds
Some bonds and other fixed income products also expose the investor to exchange rate risk (also known as currency risk). This happens when the investor purchases bonds that have cash flows in a foreign currency instead of his domestic currency. In such a case, when the investor receives the foreign currency-denominated cash flow, he will have to convert the same into his domestic currency at the prevailing exchange rate exposing him to currency risk.
Consider a US-based portfolio manager who purchases a bond that has its cash flows in Euro. Since the managers domestic currency is US dollars and the bond’s cash flows are in euros, he faces exchange rate risk, in case the foreign currency (euro) depreciates. Let’s say each coupon payment is EUR 10,000 and the initial exchange rate is 1 EUR = 1.5 USD. In that case, he expects to receive a cash flow of USD 15,000. However, if euro depreciates and the new exchange rate is 1 EUR = 1.4 USD, then the actual payment he will receive will be USD 14,000 lower than his expectations.
To conclude, exchange rate risk in bonds is the risk that the portfolio manager’s domestic cash flow will reduce because of a change in the exchange rate.
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