Introduction
Many things play a role in determining the value of an investment and currency exchange rates are one of them. This holds specifically true for investors with exposure to the international markets or investors having assets in foreign currencies. It is crucial, now more than ever, to observe the impact currency exchange rates have on investments because of the intermingling of the global economies. This will help investors manage risks effectively while also increasing their returns.
Every country’s currency is highly volatile with fluctuations due to inflation, geopolitical stability, public debt and a nation’s economic health, among other factors.
What Are Currency Exchange Rates?
A currency exchange rate is the rate at which one currency is exchanged for another. Even though most currencies are national currencies, some, like in Hong Kong can be sub-national or supra-national like the Euro. This exchange rate is controlled by factors like the interest rates in the market, economic activity, the unemployment rate of different countries and the gross domestic product.
Currency exchange rates, also called market exchange rates, are determined in the global financial marketplace. Keeping in mind the factors mentioned above, various financial institutions and banks will trade currencies around the clock here.
Types of Exchange Rate Systems
When we consider the foreign exchange market, three exchange systems in particular exist:
- Fixed Exchange Rate System :
A fixed exchange rate system compares two currencies and sees the weaker currency’s exchange rate being attached or tied to the stronger currency’s exchange rate.
- Flexible Exchange Rate System:
A flexible exchange rate system depends on the supply and demand aspects of the market and does not include or allow the intervention of either governments or central banks.
- Managed Floating Exchange Rate System:
This is a combination of the fixed-managed and floating exchange rate systems where central banks may participate in purchasing and selling foreign currencies
How Do Currency Exchange Rates Influence Investments?
Since the strength of the economy of any country influences the currency exchange rates, any fluctuations in the latter will have either a positive or negative effect on the economy and vice versa. If a country’s economy is strong, its currency becomes stronger. This will further lead global investors to invest in that country’s stock market.
For example, if someone has invested in US stocks and then there are reports of the dollar weakening against the rupee, this would mean that though the investment in rupees is getting appreciated, the total return on the investment would fall as the investment is originally in a US company.
Factors That Affect Currency Exchange Rates
Several factors affect currency exchange rates. Some of them are listed below:
- Inflation: Countries having low inflation rates consistently, usually have rising currency values, while countries with higher inflation rates face currency depreciation.
- Interest Rates: Countries with high interest rates enable lenders to earn more, attracting more foreign capital and increasing the currency exchange rates.
- Deficits: If a country is spending more to buy than its earnings means that it will need to borrow money from abroad to offset the difference. This lowers the country’s exchange rate.
- Debt: Large public debt in a country = high inflation, weakening its currency
- Import-Export: If a country's exports > imports, the currency exchange rate grows
Role of Currency Exchange Rates in Specific Investment Types
Currency exchange rates influence specific investments in many ways.
- Mutual funds:
When mutual funds have exposure to international markets or hold assets in foreign currencies, they become influenced by the currency exchange rate of Indian investors. To steer clear of any negative impact that currency exchange rates might have on the funds, strategies like currency hedging might be taken up by individuals.
- Domestic Investments
Companies that are dependent on raw materials or components coming via imports will have to shell out more upon the depreciation of the Indian Rupee. This will further impact the company’s stock prices and profits too.
Conclusion
There is no debate that the currency exchange rates of a country end up affecting several aspects on the investment front. This is why investors must stay aware and observant of any kind of currency movements. These movements play a huge role in impacting the profits of companies, the value of assets in an investor's portfolio and even the performance of a country’s economy Once investors gain more knowledge about the workings of the currency exchange rates, they can make informed decisions to help mitigate any potential risks thus gaining higher returns
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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