How Exchange Rate Affects Investments?

A common belief among people is that changes in the currency exchange rate do not affect them until and unless they are planning a foreign holiday, buying something imported or are investing in currencies. Unfortunately, that’s not completely true. Exchange rate fluctuations can have an indirect impact on your financial investments in more ways than one. If you want to know how, read on further.

What is exchange rate fluctuation?

The exchange rate is usually defined as the rate at which a country’s currency may be converted into the currency of another country. For instance, if the USD/INR exchange rate is 75, it means that you will need to shell out INR 75 to buy US $1.

Now, this exchange rate fluctuates daily due to the currency market trading that happens across the world 24x7 five days a week. The basic dynamics of demand and supply pull up and push down the exchange rate of your home currency compared with another currency.

Even if you are not involved in currency investment at all, this fluctuation can still have a large impact on your stock or bond market investments, broadly in two ways:

1. If you have invested in the international financial market

   Suppose you are an Indian who has invested money in the stock of a company that is listed in the US. You bought the shares in dollars and are now waiting for the prices to appreciate by say 10% due to an upcoming event that is seen as a game-changer for this US company.

   Let us assume that the stock price did appreciate 10% after a month. But during the same time, the dollar weakened against the US dollar by 10%.

   Then what actually happened is that though in the US dollar terms, you made a return of 10% on your investment. But when you convert the dollar profit back into rupees and transfer the amount into your bank account, the net return could be negative as the trading profit got offset by currency fluctuations.

   The same can happen if you invest in any kind of international asset class. The profits or losses can get amplified or muted depending on the currency rate movement.

2. If you invest in the domestic market
   
   Even if you invest in stocks of Indian companies on Indian stock exchanges, you are still exposed to the risk of currency exchange rate fluctuations.
   
   Suppose you buy a share of a company that is denominated in your own currency (Indian rupees). Now, say this company derives half of its earnings from foreign operations in the UK. In case the rupee weakens 10% against the pound, the company will take a direct hit on its earnings. The profit from operations abroad would reduce by 10%. This means total profit of the company (both from domestic and international operations) would be down 5%.
   Let’s take another case. Say the company has no presence in the UK, but it sources most of its raw materials from there. Then also its cost would increase when the rupee weakens compared with the pound as it would have to pay more for its purchases.

   So basically, the rise and fall of the rupee affect the earnings prospects of Indian companies in many ways, which reflect in their stock prices and dividends and, in turn, on your investment portfolio.