Tackling Currency Risk When Purchasing Foreign Bonds
Consider this Scenario
Your friend Lucy is a US resident who bought a British bond at par with a £10,000 value at maturity. The bond was exactly one year from maturity at the time she purchased it and it pays a 2% semi-annual coupon. There are two coupon payments remaining including the payment at maturity.
At the time of purchase the currency exchange rate was $1.40 US Dollars to £1.00 British pounds.
The exchange rate was $1.35 US dollars to £1.00 pounds at the time of the first coupon payment.
The bond will mature today, and the exchange rate is now $1.30 US dollars to £1.00 British pounds.
Lucy believes she made money in US dollar terms on this transaction even though the bond trades in a foreign currency. After all, she bought the bond at par, received two coupon payments and received the proceeds at par.
Did Lucy make money in US dollar terms on this transaction? How much money did she make or lose?
- Lucy lost a total of $200 on the transaction
- Lucy lost a total of $735 on the transaction
- Lucy gained a total of $200 on the transaction
- Lucy gained a total of $735 on the transaction
B is the best answer.
Lucy purchased the bond for £10,000 or $14,000 (£10,000 x $1.40) since £1 = $1.4 US Dollars
Lucy received a coupon payment for £100 (£10,000 x 0.02 /2 = £100). Converting to US dollars, she received $135 (£100 x $1.35 = $135).
Lucy received maturity proceeds of £10,000 or $13,000 (£10,000 x $1.30) and a coupon payment of £100 or $130 (£100 x $1.30 = $130).
Lucy paid $14,000 and received $13,000 in maturity proceeds and $265 ($130 + $135) in coupon payments. So, Lucy lost $735 on the transaction due to changes in the exchange rate.
An investor is subject to currency risk whenever they own an investment that is denominated in a foreign currency. In this example, Lucy lost money on the transaction solely due to the change in exchange rates between US dollars and British pounds.
US Investors can avoid currency risk in foreign bonds by purchasing dollar denominated foreign bonds. Investors can also hedge against currency movements by using options strategies, but these types of strategies are typically very complex and prohibitively expensive for a non-institutional investor. Lucy should consider working with a financial advisor who can help her understand the different risks in her portfolio.