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 called a Eurodollar deposit.
The name can be misleading: the dollars don’t have to be in Europe. If US Dollars are held in Ecuador, Nigeria, or South Korea, they’re still Eurodollar deposits.
A Eurobond is a debt security that pays interest and principal in a currency other than the currency of the country where it’s issued.
For example, suppose a Japanese company plans to build a factory in Canada. The company notices demand in Canada for Japanese Yen and decides to issue a Yen-paying bond in Canada to finance the project. Canadian investors who buy this bond face currency (exchange rate) risk, which is the potential for loss caused by changes in currency exchange rates.
Here’s why: the investors receive interest payments in Japanese Yen over the life of the bond (and the principal at maturity). At some point, those Yen will be converted back into Canadian Dollars. If the Japanese Yen weakens relative to the Canadian Dollar (which is the same as the Canadian Dollar strengthening relative to the Yen), each Yen converts into fewer Canadian Dollars. That reduces the investor’s proceeds after conversion.
To summarize, currency risk occurs when:
*A currency’s strength or weakness is always compared to another currency. For example, the US Dollar is considered strong compared to the Vietnamese Dong. Stating the Dong is weak compared to the US Dollar is essentially saying the same thing.
Currency risk generally comes up when an investor must convert one currency into another. In most cases, it isn’t a concern for American investors buying securities denominated in US Dollars.
However, an investor can still be exposed to a “second-hand” version of this risk. For example, a company that sells goods and services internationally (and receives revenue in many different currencies) may see its earnings fall when exchange rates move against it. If currency risk significantly affects profits, the company’s stock price could decline.
A Eurodollar bond is a specific type of Eurobond that pays in US Dollars. It’s a debt security that pays interest and principal in US Dollars but is issued outside 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 have yet to discuss it, 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 especially attractive to a US issuer because the issuer gains access to foreign investors without taking on currency risk. From the issuer’s perspective, a domestically issued bond and a Eurodollar bond are similar: both pay interest and principal in US Dollars.
Foreign issuers, however, may 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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