There are several risks in investments. You must be familiar with inflation risk where inflation eats up the value of your money. There’s credit risk in debt funds where a company might default on bond principal and interest payments. There is also reinvestment risk where the money you take out of your fixed income investment may not earn the same interest in a new investment.
Bonds have interest rate risk which depends on how sensitive bond prices are to interest rate changes in the market. The sensitivity depends on time to maturity and bond coupon rate. There’s political risk where political changes can affect a business and of course business risk where macroeconomic changes affect the business.
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Currency risk is the risk of change in the value of one currency vs another currency. The Rupee could gain or lose against the Dollar. You might not get the full value of an investment during to currency volatility. This is currency risk.
Let’s say you plan to go to the US on a holiday. It currently costs $5,000. (1 Dollar = Rs 68). When you go the following month to book the holiday, the cost of your trip remains the same at $5,000. Sadly, 1 Dollar is now equal to Rs 70. You have to shell out 2 more rupees for each dollar. That’s a whopping Rs 10,000 more. This has happened because of currency risk and volatility. For all spends in International Currency (Dollar, Euro, Yen, and Sterling Pounds), there’s currency risk.
Let’s say you invest in an overseas theme. You have invested in an ETF which has exposure to Nasdaq 100. There are 2 components which affect overall returns. The performance of the actual ETF (This means the return of the ETF in dollars). The second part you need to check is the currency translation. If Rupee falls against the Dollar you enjoy higher returns and vice versa if the rupee gains against the dollar.
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Common causes of rupee depreciation are high inflation and an easy monetary policy. Inflation makes India’s exports less competitive (Because of inflation exports are more costly). This widens the trade deficit. Rupee depreciates against the Dollar as imports rise amidst falling exports.
Depending on your financial goals, assets and holidays abroad, you can track currencies. If you have lots of assets in the Eurozone, track Euro vs Rupee movements. If you plan to holiday in the US, track Dollar vs Rupee movements.
Businessmen and large investors protect investments against currency risk. This can be done by hedging. Currency hedging protects against currency movements and is an insurance policy against currency risk.
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Let’s say you are an exporter who receives payment for goods in dollars. The current Dollar vs Rupee is Rs 68 to a Dollar. You are worried that the rupee might appreciate against the Dollar. Now, if the rupee gains against the dollar you (exporter) stand to lose. You are frightened that 1 Dollar will be Rs 65 in 3 months time. (This is when you get payment for the consignment in dollars. You lose Rs 3 on each dollar if rupee gains against the dollar. Currency hedging protects you from this risk.
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You hedge USD-INR at Rs 67 a dollar. You get into a futures agreement where the opposite party agrees to an exercise price of Rs 67 a dollar on 3 months expiry. (This is an obligatory contract). If rupee gains against dollar to Rs 65 a dollar, you don’t suffer a loss as the settlement takes place at Rs 67 a dollar on the maturity date. Your motive might be profit, but currency hedging protects against loss. You at least get Rs 67 a dollar instead of Rs 65 and protect against loss.
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