Question : What is the term used to describe the risk that changes in exchange rates will impact the ability of a borrower to repay a foreign currency-denominated debt?
Option 1: Credit risk
Option 2: Interest rate risk
Option 3: Sovereign risk
Option 4: Currency risk
Correct Answer: Currency risk
Solution : The correct answer is (d) Currency risk.
Currency risk refers to the risk that changes in exchange rates will impact the value of investments, cash flows, or debts denominated in foreign currencies. In the context of a borrower with foreign currency-denominated debt, currency risk refers specifically to the risk that changes in exchange rates will affect the borrower's ability to repay the debt.
When a borrower has debt denominated in a foreign currency, fluctuations in exchange rates can significantly impact the repayment obligations. If the borrower's domestic currency depreciates against the currency in which the debt is denominated, the borrower will need to use more of their domestic currency to repay the debt. This can increase the burden of repayment and create challenges in meeting the debt obligations.
Currency risk is particularly relevant for entities that have significant foreign currency-denominated debt, such as multinational corporations or governments that borrow in foreign currencies. It is important for borrowers to assess and manage currency risk by implementing strategies like hedging or diversifying their debt portfolio to mitigate the potential impact of exchange rate fluctuations.
