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Understanding the correlation between currency exchange rates and your investments

currency tradingcurrency trading in Indiacurrency trading marketforex trading
28 Jun 20246 mins readBy MOFSL

Introduction:     

The US dollar serves as the world's primary reserve currency, meaning that all other currencies are valued against it. The strength or weakness of a country’s currency is typically determined by its performance relative to the dollar. 

Currency exchange rates are highly dynamic and subject to frequent fluctuations. These exchange rate fluctuations can significantly impact various economic activities, including your investments. Let's explore this topic further.

Understanding currency exchange rates 

The exchange rate is the rate at which one currency is converted into another. For instance, if the Indian Rupee (₹) is currently valued at ₹ 83 against the US dollar ($), this is the exchange rate between these two currencies.  

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Currency exchange rates often fluctuate due to several factors, including the exchange policy of the country’s central bank, the rate of inflation, government debt, speculation, and more.

Effect of foreign exchange rate on investments

Currency exchange fluctuations can impact your investments in a number of ways, as explained below:​​​​​​

1. Increases the risk profile of mutual funds investing in foreign markets

Some mutual funds invest in international stocks to offer exposure to global markets. While this can be a great way to diversify a fund’s portfolio, it also adds risk due to exchange rate fluctuations. If the Indian Rupee strengthens, the value of foreign assets that the fund invests in decreases when the profits are converted back to rupees. On the other hand, a weak Indian Rupee can enhance the value of the foreign assets. Therefore, it can be beneficial to time your investments according to the value of the rupee.  

2. Results in increased or decreased foreign investments 

If the value of the Indian Rupee escalates against the US dollar, international investors tend to invest less in the Indian market because it becomes more expensive for them. They have to spend more money to buy stocks, bonds, and other investments. When this happens, foreign investment decreases, which can potentially impact stock prices. Conversely, when the Indian Rupee depreciates, international investors find it cheaper to invest in India and invest more. This influx of foreign capital can drive up stock prices by bringing more money into the market.

3. Causes fluctuations in the stocks of export and import businesses

Investing in the stocks of companies that export or import goods can be complex. For export-oriented businesses, a depreciating Indian Rupee can boost sales and bring in more business as their goods become cheaper in the global market. However, a depreciating rupee can increase the cost of goods and services for import-oriented firms, making it harder for these companies to earn a profit. Therefore, investing in the stocks of such companies can add risk to your portfolio by exposing you to exchange rate fluctuations. 

Things to keep in mind about exchange rate changes when investing in domestic and foreign markets​​​​​​​

1. When investing in foreign stocks, changes in currency exchange rates can significantly affect your returns. While the general principle is that an increase in stock prices leads to a profit, this may not always hold true when dealing with foreign stocks. Even if the stock's value increases, a weakening foreign currency against your home currency can diminish or even negate your profits when you convert them back. Unfavourable currency fluctuations can offset your investment gains and potentially result in lower net returns than expected.  

2. Investing in domestic companies can also expose you to currency exchange rate risks. Many Indian companies rely on foreign businesses for raw materials or other operational needs. In such cases, a weaker Indian Rupee can reduce a company’s earnings from foreign operations when converted back. Additionally, it can increase costs for imported raw materials, thereby affecting profit margins and overall company performance. Thus, even if you focus on domestic stocks, currency movements can still impact exchange rates and influence the financial health of Indian companies operating in domestic markets. Understanding these risks is crucial when selecting stocks for investment.

To sum it up

Currencies are prone to fluctuations that can significantly affect your investment profits. While these fluctuations are beyond your control, understanding their impact is crucial. Various factors influence the value of the Indian Rupee. Whether you choose to invest in international stocks or domestic companies, being informed about currency dynamics can help you make rational investment decisions

 

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Disclaimer: The stocks, companies, or financial instruments mentioned in this blog are for informational purposes only and should not be considered as investment recommendations. It is advised to consult with your financial advisor before making any investment decisions. Investment in securities markets are subject to market risks, read all the related documents carefully before investing. Investors are strongly encouraged to carefully read the risk disclosure documents prior to participating in market-related investments or trading activities. Due to the volatile nature of financial markets, no guarantees can be made regarding investment returns. Motilal Oswal Financial Services Ltd. does not offer any assured returns on market-linked securities. Please note that past performance of stocks or indices is not indicative of future results.
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