The US Dollar is considered the world’s reserve currency, so many goods and services around the world are bought and sold in dollars. Because of that, it’s common to find US Dollars held in banks outside the United States. When a US Dollar is held in an account outside the United States, it’s known as a Eurodollar deposit.
The name can be misleading: the deposit doesn’t have to be in Europe. If US Dollars are held in accounts in Ecuador, Nigeria, or South Korea, they’re still 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 factory. Canadian investors who buy this bond face currency (exchange rate) risk, which is the potential for loss related to currency conversion. This is the same risk discussed in the American Depositary Receipts (ADRs) and Foreign investing chapters.
When the exchange rate between the Japanese Yen and Canadian Dollars changes, it can create gains or losses for the Canadian investors. Over the life of the bond, investors receive interest in Japanese Yen (and principal at maturity). At some point, those Yen will be converted back into Canadian Dollars.
Currency risk shows up if the Japanese Yen weakens (which is the same as the Canadian Dollar strengthening). The weaker the Yen becomes, the fewer Canadian Dollars investors receive when they convert the bond proceeds.
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 risk isn’t a concern for American investors purchasing securities denominated in US Dollars.
However, an investor can still be exposed indirectly. For example, a company with international sales (in many different currencies) may experience losses due to exchange rate fluctuations. If those currency moves significantly reduce earnings (profits), the company’s stock price could fall.
A Eurodollar bond is a specific type of Eurobond that pays in US Dollars. Specifically, it’s a debt security that pays interest and principal in US Dollars but is issued outside of the United States.
Because the US Dollar is in global demand, Eurodollar bonds are popular worldwide. They’re issued by many 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 can be attractive for a US issuer because the issuer faces no currency risk but gains access to funding from foreign investors. From the issuer’s perspective, a domestically issued bond and a Eurodollar bond are similar in a key way: both pay interest and principal in US Dollars.
Foreign issuers, however, face currency risk because they may need to convert from their primary currency into US Dollars to make interest and principal payments. Foreign investors can face currency risk as well, since they may need to convert the US Dollar payments back into their home currency.
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