Exchange rate tells you how much foreign currency (say, dollar, euro or Chinese renminbi) you can get in exchange for a unit of your currency.
EVER since India opened up its market, an increasing number of multi-national companies have invested in the country. Likewise, a large number of Indian companies have invested abroad or are doing business with foreign partners and clients. One factor that plays a key role in the fortunes of such companies and their investors’ money is the rate of foreign exchange.
Most investors ignore exchange rate fluctuations as they assume it is for those who travel, study or live abroad, and remit money home. However, with increased integration of businesses and stock markets around the world, this assumption no longer holds.
Exchange rate fluctuation
Exchange rate tells you how much foreign currency (say, dollar, euro or Chinese renminbi) you can get in exchange for a unit of your currency. Rates fluctuate because of supply and demand and due to differences in interest rate and fluctuation across the world.
The other reason for fluctuation is how countries manage the exchange rate. Some countries follow fixed exchange rate policy, where their government fixes the rate. Other nations follow market exchange rate, allowing demand and supply in the market to define the exchange rate. Few others, India included, follow a hybrid model where the government does not interfere if the currency is fluctuating within a certain range; when the exchange rate goes out of a prescribed range, the government comes into the picture.
Impact on investment
Certain sectors are prone to exchange rate fluctuations. Usually, any company that either imports or exports goods and services faces the risk of exchange rate fluctuation. Those who have invested directly in company shares or through mutual funds will experience fluctuations in their capital gains or dividend income.
When the rupee appreciates: Companies where exports comprise a large part of revenues are impacted by currency appreciation. Let’s suppose a US company buys software worth $100 million every year from an Indian vendor. At an exchange rate of R50 a dollar, 1 dollar can be used to buy Indian goods worth R50. The Indian vendor makes $25 million (or R125 crore) in profit. Now, if the exchange rate goes up to R40 a dollar, the Indian vendor makes only R100 crore as he has priced his software in dollar.
This fall in profits can either hit the company’s share prices adversely and, thus, bring down the investor capital gains, or reduce the dividends he would have received had the profits not fallen.
Companies that import from foreign markets benefit when currency appreciates. Usually, the dollar is preferred when countries do business. Suppose ONGC imports oil from gulf countries worth $100 million in a year. If the exchange rate appreciates from R50 a dollar to R40 a dollar, ONGC’s spend goes down from R500 crore to R400, a saving of R100. Here, an ONGC investor would tend to get capital gains or dividend income from his investment.
When the rupee depreciates: The situation reverses in this case. When the rupee depreciates against the dollar, exporters benefit because one dollar can buy more goods. However, it is detrimental for importers because their bill goes up and, very often, it is not possible to increase prices to compensate for extra expenses. This hits their profit.
Mutual funds and currency fluctuations
Many mutual funds invest in specific sectors or indices. A few funds may invest heavily in a particular sector. For example, if a mutual fund invests majorly in IT, textiles, or pharma, currency fluctuation will hit the returns of the investors of the mutual fund. Similarly, a few fund houses have launched mutual funds that invest money across the globe. These funds are very prone to currency rate fluctuation.
The writer is CEO, BankBazaar.com