The US Dollar is considered the world’s reserve currency, resulting in a significant number of goods and services bought and sold around the world in dollars. For this reason, it’s not uncommon to find our currency in foreign countries. When a US Dollar is held in an account outside the United States, it is known as a Eurodollar deposit.
Don’t get confused with the name - even if the US Dollar is held in a foreign country outside of Europe, it’s still considered a Eurodollar deposit. For example, US Dollars held in accounts in Ecuador, Nigeria, or South Korea are Eurodollar deposits.
A Eurobond is a debt security that pays interest and principal in a denomination other than the currency of the country it was issued in. For example, assume a Japanese company plans on building a factory in Canada. The company finds there’s Canadian demand for the Japanese Yen, and decides to issue a Yen-paying bond in Canada to finance the building of the factory. Canadian investors purchasing this bond would be faced with currency (exchange rate) risk, which occurs when there’s the potential for loss related to currency conversion. This is the same risk we discussed in the American Depositary Receipts (ADRs) and Foreign investing chapters.
When the currency exchange rate between the Japanese Yen and Canadian Dollars fluctuates, it could result in losses for the Canadian investors mentioned above. As Canadian investors receive interest in Japanese Yen over the life of the bond (and the principal at maturity), the currency will eventually be converted back to Canadian Dollars. Currency risk would occur if the Japanese Yen weakened (same as the Canadian Dollar strengthening). The weaker Yen becomes, the fewer Canadian Dollars received when the bond’s proceeds are converted. To summarize, currency risk occurs when:
*The strength or weakness of a currency is always in comparison to another currency. For example, the US Dollar is considered strong in contrast to the Vietnamese Dong. Stating the Dong is weak as compared to the US Dollar is essentially saying the same thing.
Currency risk generally occurs when an investor must convert one currency to another. In most circumstances, this type of risk is not a concern for American investors purchasing securities denominated in US Dollars. However, an investor could face a type of “second-degree” version of this risk. For example, a company with international sales of its goods and services in many different currencies may face losses due to currency rate fluctuations. This could lead to the stock price falling, especially if the currency risk significantly impacted the company’s earnings (profits).
A Eurodollar bond is a specific type of Eurobond, but one that pays US Dollars. Specifically, a Eurodollar bond is a debt security that pays interest and principal in US Dollars but is issued outside of the United States. Given the US Dollar is in demand globally, Eurodollar bonds are fairly popular around the world. They are issued by all types of organizations, including:
*We will learn about municipalities and the securities they issue later in this material, but for now, assume a municipality is a government below the federal level. State, city, and local governments are considered municipalities.
American municipalities have a history of issuing Eurodollar bonds, but the federal government does not. We haven’t discussed it yet, but Treasury securities are some of the most demanded securities in the world. The US Government (the issuer of Treasuries) offers them at their Treasury auction, which always occurs in the United States. Essentially, the US Government forces foreign investors to come to them. Therefore, the US Government does not technically issue Eurodollar bonds.
Eurodollar bonds are particularly enticing for an American issuer, as they face no currency risk, but gain access to funding from foreign investors. A domestically issued bond and Eurobond are relatively the same for these issuers - both pay interest and principal in US Dollars. Of course, foreign issuers face currency risk, as a conversion from their primary currency to US Dollars must occur in order to make required interest and principal payments. Additionally, foreign investors face the same risk, as they must convert their bond proceeds into their home currency.
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