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The exchange rate represents the value of one currency in relation to another. For an investor in India, changes in the value of the rupee relative to currencies like the US dollar can affect foreign shares, mutual funds, and bonds.
The same changes can also affect domestic companies that import raw materials or derive revenue from overseas markets.
This article explains how exchange rates affect investment returns.
Key Takeaways
- The value of the rupee in returns from foreign investments can be affected by changes in exchange rates.
- When the rupee strengthens, the returns on overseas assets fall as they are converted back into rupees.
- If the rupee becomes weaker, the value of foreign investments in rupees will rise, provided that the price of the underlying asset does not change.
- Domestic companies may also be exposed to currency risk due to their imports, exports, and overseas operations.
- Currency futures and options may be used to manage certain foreign exchange risks.
What is an Exchange Rate?
An exchange rate indicates the amount of one currency that is required to purchase another currency. For instance, if the USD/INR exchange rate is ₹95, then one US dollar is worth ₹95.
When the rate goes up from ₹95 to ₹96, the rupee has depreciated against the dollar, so an Indian investor will have to obtain more rupees in order to buy the same amount of dollars.
Currency values move for several reasons, including:
- Interest rates
- Inflation
- Economic growth
- Government debt
- Trade balances
- Political and geopolitical conditions
- Central bank policies
- Market expectations and speculation
The factors in question can affect the demand for a currency and thus influence investment markets.
Purchasing Power Parity (PPP) and Long-Term Trends
Over extended horizons, exchange rates tend to gravitate toward Purchasing Power Parity (PPP). For example, if India's inflation rate runs higher than the United States' over the long term, the rupee's purchasing power declines faster. This economic differential naturally results in a structural depreciation of the INR against the USD over multi-year periods.
How Does a Stronger Rupee Affect Foreign Investments?
Let an Indian investor purchase US shares worth $1,000 at the then-current exchange rate of ₹95 per $1.
Investment value in rupees:
$1,000 × ₹95 = ₹95,000
Suppose that the value of the US shares stays at US$1,000, but the rupee appreciates and the exchange rate drops to ₹92.
New rupee value:
$1,000 × ₹92 = ₹92,000
The amount invested has not changed in dollar terms, but its value in rupees has dropped by ₹3,000 due to the currency change.
This is referred to as currency risk. The total return may still be increased or decreased by exchange-rate changes when the investment is converted into rupees, even if the foreign asset itself performs well.
How Does a Weaker Rupee Affect Foreign Investments?
The reverse may occur if the rupee loses value.
Suppose that the same investment of US$1,000 is purchased at a rate of ₹95 per dollar; if the exchange rate afterwards climbs to ₹98, then the investment becomes:
US$1,000 × ₹98 = ₹98,000
The foreign asset remains worth $1,000, but its value in rupees has increased by ₹3,000 as the dollar has strengthened relative to the rupee.
Currency movements may increase or decrease investment returns, depending on both the performance of the foreign asset and the change in the exchange rate.
How Does Exchange Rate Affect Mutual Funds?
Currency fluctuations can likewise affect mutual funds that invest in foreign shares or bonds. For instance, an Indian mutual fund could invest in American equities.
The investor would then be able to gain from both the increase in the value of US stocks and the strengthening of the dollar relative to the rupee.
The opposite can happen as well: a foreign portfolio might rise in value when measured in its own local currency, but a weaker rupee could lower the return once it has been converted into rupees.
So, investors looking at international mutual funds need to consider two components:
- Performance of the underlying foreign assets
- Movement in the relevant currency
Currency changes can thus form a significant component of the total return from an international investment.
Can Exchange Rates Affect Domestic Investments?
Certainly. The risk relating to currency is not confined to investors who directly hold foreign assets. It is common for Indian companies to import raw materials, machinery, energy products, or other goods.
When the rupee depreciates against the currency used for these purchases, the cost of the imports rises.
For example, an Indian manufacturer which imports raw materials priced in US dollars will have to use more rupees to pay the same dollar-denominated bill when the dollar.
This may lead to higher operating costs and have an effect on profit margins. Should earnings fall, the company's share price could also be affected.
The opposite can be true for exporters: a weaker rupee can cause the revenue obtained in foreign currencies to amount to a higher value when it is converted back into rupees.
Although the actual result will depend on the company's costs, pricing, and hedging arrangements.
Which Investments are Most Exposed to Currency Risk?
| Investment | How exchange rates can affect returns |
| Foreign stocks | Changes the rupee value of the investment |
| International mutual funds | Affects the value of foreign assets after conversion |
| Foreign bonds | Influences both asset value and converted returns |
| Export-oriented companies | Currency movements can affect overseas revenue |
| Import-dependent companies | A weaker rupee can increase input costs |
| Currency derivatives | Their value directly depends on currency movements |
The extent of exposure varies from one investment to another; even an investor who holds only domestic assets could still come up against indirect currency exposure through the companies included in the portfolio.
How can Currency Risk be Managed?
It is not always possible to eliminate currency risk, but there are some financial instruments that can be used to manage it. There are two types of such financial instruments: currency futures and currency options.
In India, these currency futures and options are traded on the exchanges, one of the main currency pairs being the USD/INR.
Suppose there is someone who anticipates having to make a big payment in dollars at a later date.
If the rupee depreciates before the payment is due, they will then have to spend more rupees.
A currency derivative may be used in order to hedge against an adverse movement in the currency. The aim is not necessarily to gain a profit from the movement in the currency but rather to reduce the uncertainty concerning the future cost.
Derivatives come with their own risks and demand that one understands contracts, margins, and price movements.
Regulatory Requirements for Currency Derivatives in India
As per RBI guidelines, market participants and retail investors trading Exchange-Traded Currency Derivatives (ETCD) on recognised stock exchanges (like NSE and BSE) must have a contracted underlying exposure (such as genuine trade or travel receivables/payables, or underlying foreign investments). Purely unhedged speculative position-building without demonstrable underlying exposure is restricted, requiring brokers to verify client exposures before trade execution.
Difference Between Direct and Indirect Currency Exposure
Direct exposure happens when an investor holds an asset that is denominated in a foreign currency, for example, US stocks.
Indirect exposure occurs when a domestic company is affected by currency fluctuations resulting from its business activities.
For example, an Indian company which imports raw materials priced in dollars will find its costs increasing if the rupee depreciates, while an exporter who earns revenue in dollars may have a different situation.
The difference is important since an investor can have currency exposure even if they do not hold any foreign shares.
What Should Investors Check Before Investing Overseas?
It is useful, before you invest in an asset in a foreign country, to consider aspects other than the return that the asset will produce in the currency of its home country.
- Currency used to express investment.
- Investor's home currency.
- Historical fluctuation between the two currencies.
- There is a currency-hedging arrangement regarding investment.
- What portion of the entire portfolio is affected by foreign currencies?
- The impact of converting the currency on the final return is great.
A foreign investment that seems attractive in its local currency may yield a different outcome when converted to rupees.
Investing via the Liberalised Remittance Scheme (LRS)
For Indian resident individuals, outward foreign investments in shares, mutual funds, or overseas bank accounts are routed through the Reserve Bank of India’s (RBI) Liberalised Remittance Scheme (LRS).
Under LRS, resident individuals are permitted to remit up to a specified limit per financial year for permissible capital and current account transactions. Investors must factor in applicable LRS remittance charges, bank processing fees, and TCS (Tax Collected at Source) rules when calculating their initial deployment outlay.
Tax Implications of Currency Gains on Foreign Investments
Under Indian income tax laws (such as Section 48 of the Income-tax Act), when calculating capital gains on foreign assets, the purchase and sale values must be converted into Indian Rupees (INR) using the applicable exchange rates on the respective dates. Consequently, any gains arising from the depreciation of the rupee against the foreign currency can increase your capital gains in INR terms, thereby impacting your overall tax liability. Investors should account for these currency-driven gains when computing short-term or long-term capital gains tax.
Conclusion
Exchange rates can have an impact on investment returns in more than one way. A stronger rupee will lower the value of foreign investments in rupees, whereas a weaker rupee will raise it. Moreover, changes in the currency can affect domestic companies via import costs, export revenues, and their overseas operations.
