Question

On international financial crises:
2. What are interest rate risk, credit risk and exchange rate risk?

Answer 1

1. Interest rate risk is the possibility that the value of an investment will decline as the result of an unexpected change in interest rates. This risk is most commonly associated with an investment in a fixed-rate bond. When interest rates rise, the market value of the bond declines, since the rate being paid on the bond is now lower in relation to the current market rate. Consequently, investors will be less inclined to buy the bond; since demand declines, so too does the market price of the bond. This means that an investor holding such a bond would experience a capital loss. The loss is unrealized as long as the investor chooses to continue holding the bond, and will be realized once the bond is sold or reaches its maturity date.

   Shorter-term bonds have a lower interest rate risk, since there is a shorter period of time within which changes in interest rates can adversely impact the bonds. Conversely, there is a higher interest rate risk associated with longer-term bonds, since there may be many years within which an adverse interest rate fluctuation can occur. When a bond has a higher level of interest rate risk, its price will fluctuate more when there is an adverse change in the interest rate.

2. Credit risk, or default risk, is the risk that a financial loss will be incurred if a counterparty to a (derivatives) transaction does not fulfil its financial obligations in a timely manner. It is therefore a function of the following: the value of the position exposed to default (the credit or credit risk exposure); the proportion of this value that would be recovered in the event of a default; and the probability of default.

   Credit risk is also used loosely to mean the probability of default, regardless of the value that stands to be lost.

3. Exchange-rate risk, also called currency risk, is the risk that changes in the relative value of certain currencies will reduce the value of investments denominated in a foreign currency.

   Exchange-rate risk matters because exchange rates affect the amount of money the investor actually sees at the end of the day, and this in turn determines what the investor's rate of return ultimately is.
   
   However, exchange-rate risk can create opportunities because the interest rates between two countries often reflect expected changes in the exchange rate between them. For example, if interest rates are higher in Canada, the U.S. dollar will probably decline in value relative to the Canadian dollar. (This is because when interest rates increase in a particular country, international money flows into that country to capture the higher yields. This pushes the value of that country's currencyhigher.) Exchange-rate risk also means that investors in foreign bonds can indirectly participate in the foreign-exchange markets.