We all know about the Market Risk; wherein we lose money if the share prices fall.
We all know about the Default Risk; wherein we lose money if the bank does not pay interest or repay our fixed deposit amount.
We all know about the Liquidity Risk; wherein we lose money (by way of exorbitant surrender charges) if we have to prematurely close our insurance policy.
However, there is another relatively lesser known risk… Currency Risk.
While this risk, not something new, it has become more common in recent years. The reason is obvious. We are holidaying outside India more often; we are sending our children to study abroad more often; we are even investing in foreign markets/properties more often.
So let’s explore how Currency Risk — also known as Exchange Rate Risk — affect us.
Currency Risk is nothing but increases in our expenses (or fall in our investments) due to change in the value of rupee as compared to the currency of the country where we wish to travel or invest.
Suppose I plan to travel to the US after two months. The expenses are estimated at around US$ 10,000. With the exchange rate at Rs.65 per dollar, I have to arrange for Rs.6.50 lakhs.
However, two months later the US currency has become more expensive at Rs.67 per dollar. So my actual expenses work out to Rs.6.70 lakhs. In short, due to the adverse exchange rate movement, my bill is extra Rs.20,000.
This is nothing but currency risk.
Interestingly, this currency risk has a positive aspect too:
Imagine a scenario where, two months later, the dollar is available for Rs.63 only. So I have to shell out only Rs.6.30 lakhs. And, I end up saving Rs.20,000 compared to the projected amount.
Likewise, I would have to spend ‘more rupees’ on my kid’s education, if the rupee-dollar exchange rate depreciates (or less if the rupee-dollar rate appreciates).
The reverse is true for our investments outside India — we make a profit when the rupee falls. We incur a loss when the rupee rises.
In order to diversify my portfolio, I invest in the US stock markets. I earmark Rs.10 lakhs for the same. Since the rupee-dollar rate is Rs.65, I get to invest about USD 15,400.
One year later, my US stock portfolio is up 10% to USD 16,940. Given that US economy is growing at 2.5-3%, 10% gains are excellent.
I decide to sell and book profits. But the end result is no pleasant.
At 10% returns, I am expecting Rs.11 lakhs. However, the rupee-dollar is trading at Rs.63. So, I get back only Rs.10.67 lakhs. In other words, my effective returns are only 6.7%. I have lost 3.3% of my stock market gains to exchange rate loss.
(By the way: If the rupee were to appreciate to Rs.59 per dollar, my entire gains would be wiped out and I will receive only Rs.10 lakhs.)
And, what if instead the rupee ‘depreciates’ to Rs.67 per dollar?
If that be so, on redemption I will receive Rs.11.35 lakhs as against expected Rs.11 lakhs. Hence, my total profit is 13.50% (= 10% due to stock gains + 3.5% due to currency gains).
In fact, even if I had made NIL gains at the stock market, I would still receive Rs.10.32 lakhs as against my investment of Rs.10 lakhs. This means 3.20% profit merely because of favourable exchange rate movement.
This, in a nutshell, is how you will be impacted by exchange rate movements.
As such, you need to be conservative with your projections. When planning your expenses abroad, you must keep a cushion for rupee depreciation. Similarly, when investing abroad, you must be prepared for rupee appreciation. This would insulate you from currency shocks.