How Does Exchange Rate Affect Investment Returns?

4 mins read
by Angel One

Aniket and Hardeep are best friends and colleagues in a MNC. While Aniket is an active trader, investor and financial wizard, Hardeep has just started showing interest in the world of trading.

Aniket has been actively teaching him a lot of things since the past 2 months about topics related to mutual funds, equity market, currency futures, forex options, how to open trading account, etc. Hardeep is beginning to gain confidence and has started mutual fund investment through SIP.

Today, Aniket is explaining to Hardeep about how currency prices have a direct impact on investment returns, price of essentials, fuel costs and lending rates. Hardeep is listening intently, and naturally for a newbie, he still has a lot of questions.

Hardeep – Why do the value of forex or currencies fluctuate?

Aniket – Well, there can be several reasons for the value of a currency to come down or go up. But one thing is for sure; it has a direct impact on your investment returns and many other things.

Hardeep –Really? Will you explain in detail?

Aniket – Yes. But let me answer your first question.

The value of a currency or its foreign exchange (forex) value moves according to these six main factors:

  1. The exchange policy of the country’s central bank
  2. Rate of inflation
  3. Interest rates
  4. Current account deficit
  5. Government debt
  6. Speculation

These are six main factors that drive the value of a currency.

Hardeep – Ok. But how do forex movements affect my investment returns?

Aniket – Yes. I’m coming to that. There is a certain type of risk in investment; it is called currency risk. A sudden significant decrease in the value of the country’s currency, which seldom occurs, can wipe out your returns. However, even minor fluctuations can impact your investment returns.

Hardeep – How is the value of the currency, for example the Indian Rupee, is calculated?

Aniket – Most currencies are valued against the US dollar. Currently, the Indian currency is valued at more than Rs. 75 against the US dollar.

Current economic and political conditions also have a bearing on the value of the currency. However, the most important factors are international trade, inflation, interest rates and political stability.

Hardeep – Can I take part in currency trading?

Aniket – Yes, you can. You just need to open trading account.

In India, currency trading mostly occurs through currency futures.

Hardeep – Now, what is currency futures?

Aniket – Currency futures are not currency in themselves but they derive their value from an underlying currency such as the INR, USD, GBP, Yen & Euro traded in India. All currency futures trades are settled in INR in India.

Hardeep – Where is forex or currency trading done?

Aniket – The NSE and BSE provides trading in currency futures and currency options. Usually, the INR/USD pair is the most popular because it has greater liquidity than other currency pairs.

Hardeep – How can we protect our investments from currency risk?

Aniket – You can use derivative instruments such as currency futures and currency options, also called forex options, to protect their investments from forex movements. If you are about to spend money in a foreign currency, you can invest in a currency derivative instrument to protect yourself against rise in valuation of the foreign currency.

Imagine, you are sending your daughter to the U.S. for higher education and you have paid 50% of the tuition fees to the university in advance. Currently, the INR is trading Rs. 75 to the USD. You are worried by the time that your daughter leaves for the U.S., the Rupee may devalue further, perhaps to Rs. 80 against the dollar. Therefore, you will be paying extra for your daughter’s higher education in the next two months or so. To protect against this risk, you can buy currency futures or forex options.

Hardeep – Can small traders trade in currency futures?

Aniket – I think currency futures trading is well within reach of small retail traders. For example, the minimum cost of a USD/INR futures contract is around USD $1,000. It is 1,000 Euros for EUR/INR futures contract and 1,00,000 Yen for JPY/INR futures contract. Profit and losses in a futures contract are paid and collected on the same day, therefore there is no chance of accumulating losses.

Hardeep – Thanks my friend, for answering all my questions on forex trading today. I have really learned a lot from you in the past two months.

Aniket – My pleasure, friend!