What risk is faced by a U.S. life insurance company that buys British government bonds?

Question

What will be an ideal response?

Answer 1

From the perspective of a U.S. life insurance company investing in British government bonds, the cash flows of assets denominated in a foreign currency expose the investor to uncertainty as to the cash flow in U.S. dollars. The actual U.S. dollars that the investor gets depend on the exchange rate between the U.S. dollar and the foreign currency at the time the nondollar cash flow is received and exchanged for U.S. dollars. For a U.S. life insurance company buying British government bonds, if the British pound depreciates (declines in value) relative to the U.S. dollar, the dollar value of the cash flows will be proportionately less. This risk is referred to
as foreign exchange risk. This risk can be hedged with foreign exchange spot, forwards, futures, or options instruments (although there is a cost of hedging).

In distributing British government bonds, the Bank of England uses the ad hoc auction system. Under this system, a government announces an auction when prevailing market conditions appear favorable. From the issuing government's perspective, an ad hoc auction involves less market volatility than a regular calendar auction where yields tend to rise as the announced auction date approaches and then fall afterward. Thus, from the viewpoint of a U.S. life insurance company buying British government bonds, an ad hoc auction would not face rising yields. This would be considered disadvantageous since the U.S. life insurance company could not lock in the rising yield. Second, the U.S. company would only be able to invest in British government bonds on a regular basis. This might also be considered a disadvantage.