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How Currency Risk Haunts Your Investments And Expenses

Your investment in Fixed Deposits is prone to Default Risk... the bank / company fails to pay you interest or repay your principal amount.

Your investment in Insurance is prone to Liquidity Risk... you can't access your money without paying heavy surrender charges.

Your investment in equity / equity mutual funds is prone to Market Risk... the stock prices fall sharply, wiping away all your gains and also a significant part of your original investment.

Apart from these familiar risks to your investments, one more risk is becoming commonplace... Currency Risk.

Of course, currency risk (also referred to as the Exchange Rate Risk) is not something new. It has always been in existence, as different countries have different currencies. 

However, it has become relevant in the recent times, at least for the Indians, because...
... more and more Indians are investing more and more money abroad
... more and more Indians are sending their children to study outside India
... more and more Indians are travelling to foreign locales in vacations

This is the direct result of the Reserve Bank of India permitting liberal terms for remitting your money outside India.

What is Currency or Exchange Rate Risk?

In plain and simple terms, Currency Risk is the increase (or decrease) in the value of your investment or expenses, due to change in the value of the rupee vis-a-vis the currency of the country where you invest or travel.

Let's take a simple example:

You have planned a trip to the US, during your kids' vacations three months later. You estimate the trip to cost you around US$ 15,000. Thus, as per the present exchange rate of Rs.67 / dollar, this works out to a total expense of around Rs.10 lakhs.

However, in the interim, rupee depreciates sharply due to a sudden turmoil in the global markets. Three months later the exchange rate stands at Rs.70 / dollar. So, your actual cost of US trip would end up denting your bank balance by an additional Rs.50,000 at Rs.10.50 lakhs.

A contrary scenario too is possible:

Suppose, due to India's strong economy, rupee appreciates. Three months later only Rs.65 fetches you a dollar. Now you stand to save Rs.25,000, as your US holiday would need only Rs.9.75 lakhs.

Similarly, you will have to shell out more rupees on the college fees of your children, if rupee keeps falling while they are studying abroad. Alternatively, rising rupee will cut down your actual expenses on fees.

In short, when your non-rupee expenses are concerned, appreciating rupee is good for you and depreciating rupee is bad news.

exchange-rate-or-currency-risk
Don't let the Exchange Rate or Currency Movement scare you from investing abroad.

Exactly the opposite happens when you INVEST abroad:

Now, appreciating rupee is bad for you, while depreciating rupee is good news.

Suppose you wish to diversify your portfolio, by investing Rs.5 lakhs in the US stock market. At Rs.67 / dollar, you can buy stocks worth approx. US$ 7,500.

After a year, say your stocks have gained about 10%. Hence, your investment in dollar terms is now worth around US$ 8,250.

Logically, this should excite you.

But the end-result could be quite shocking.

During the year, the rupee has appreciated to say Rs.63 / dollar. So, when you sell your stocks and repatriate your money back to India, you end up receiving Rs.5.20 lakhs. This gives you an effective profit of 4% only. In other words, rupee appreciation has wiped out more than half your gains. And, at Rs.60.50 / dollar or below, you would be staring at an effective loss.

As mentioned, depreciating rupee is good for investments:

So, if rupee-to-dollar rate becomes Rs.70, your returns in rupee terms would jump to Rs.5.77 lakhs i.e. 15.4%. This comprises both investment gains and currency gains.

In fact, assuming you make 0% investment gains and get only your original investment of US$ 7500 back into India, you will receive Rs.5.25 lakhs. This works out to 5% gains on your investment in rupee terms.

Here I would like to mention that, in the present context, 'risk' is probably not the right word.

The word "risk" normally has a negative connotation. It denotes a threat, insecurity or danger.

Whereas, as you would have noted from the above examples, exchange rate movement can both hurt you or benefit you. Depending on which way it trends, it is sometimes a Risk and sometimes an Opportunity.

Therefore, I normally prefer to call this impact of currency movements in a more neutral context, as the Exchange Rate Effect. The effect can be both negative or positive.

If you keep this point in mind, you won't feel threatened by the currency movements. Rather, it would help you to plan your investments (or expenses) in a lot better way.

As mentioned earlier, it is only in the recent years that currency risk has become a real risk. Therefore, unlike in the West, we are yet to develop any meaningful tools to manage the risk of currency movements, especially for the individuals.

By the way, here it would be relevant to read my blog post Should you invest in Global / International Funds?.

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