How can foreign exchange risk impact investments in international bonds?

Foreign exchange risk significantly impacts investments in international bonds primarily because it arises from the fluctuating values of foreign currencies. When an investor purchases bonds denominated in a currency other than their home currency, any change in the exchange rate can impact the returns received upon maturity or interest payments.

For instance, if the foreign currency depreciates against the investor's home currency, the value of the bond's interest payments and principal repayment could diminish when converted back to the home currency. Thus, while the bond may have produced positive returns in its local market, adverse currency movements can lead to negative overall returns for the investor in their home currency.

Understanding this risk is crucial for investors considering international bonds, as it can significantly affect investment performance beyond the credit quality or interest rate risk associated with the bonds themselves. Hence, the correct choice highlights the essence of foreign exchange risk in international investments.