Exchange Rate Risk
Also written Currency risk · Foreign exchange risk
The risk that an investment’s value, measured in the home currency, changes because foreign exchange rates move. A falling rupee raises returns on foreign assets; a rising rupee cuts them.
In plain language
Buy a share in New York and you have made two bets, not one: a bet on the company, and a bet on the dollar against the rupee.
Exchange rate risk — the workbook also calls it currency risk — arises when an investment's value fluctuates because foreign exchange rates change. It mainly affects investors holding foreign assets such as stocks, bonds or mutual funds denominated in another currency.
The direction is the part people get wrong. For an Indian investor holding foreign assets, a depreciation of the rupee increases returns, and an appreciation of the rupee reduces them. The workbook's example: if an Indian investor holds US stocks and the rupee strengthens against the dollar, returns in rupees may decline.
How it works
The mechanism. A foreign asset's rupee value = foreign-currency value × exchange rate. Either term can move. Even if the foreign price is unchanged, a change in the exchange rate changes the rupee value.
Why it cannot simply be diversified away inside one market. Chapter 10 lists exchange rates, along with interest rates and commodity prices, among the common risk factors behind systematic risk — market risk that cannot be diversified. Chapter 3's economic analysis likewise lists currency exchange rates among the global trends that affect stock markets.
How much foreign exposure an Indian resident can take. Chapter 9's regulatory constraints section cites the RBI's Liberalised Remittance Scheme: resident individuals, including minors, may remit up to USD 2,50,000 per financial year (April–March) for permissible current or capital account transactions. The scheme began on 4 February 2004 with a limit of USD 25,000.
How it is hedged. Chapter 5 describes the currency derivatives market — futures, options, forwards and swaps on pairs such as USD/INR — which businesses use to mitigate foreign exchange risk, traded in India on exchanges regulated by SEBI and RBI.
The NRI angle. Chapter 11 distinguishes the NRE PMS account, which allows repatriation of funds back to the foreign country, from the non-repatriable NRO PMS account — so currency movements matter directly to an NRI measuring returns at home.
A worked example
All figures are illustrative; the workbook states the direction of the effect, not a worked number.
Sunita, a resident Indian, invests USD 20,000 in a US equity fund under LRS when USD 1 = ₹80, i.e. ₹16,00,000. A year later the fund's dollar value is unchanged at USD 20,000.
| Rupee a year later | Rupee value | Return in rupees | What happened to the rupee |
|---|---|---|---|
| ₹84 per dollar | ₹16,80,000 | +5.0% | Depreciated — return rises |
| ₹80 per dollar | ₹16,00,000 | 0% | Unchanged |
| ₹76 per dollar | ₹15,20,000 | −5.0% | Appreciated — return falls |
The underlying fund did nothing. Sunita's entire gain or loss came from the currency. Had the fund risen 5% in dollars while the rupee appreciated to ₹76, her rupee return would have been close to zero — a good investment decision cancelled out by a currency move she did not choose.
Why NISM asks about it
Chapter 1 (Investments), section 1.5.4, among the seven types of investment risk (business, financial, liquidity, exchange rate, political, geopolitical and regulatory). Questions test the definition and, above all, the direction: which way returns move when the home currency depreciates or appreciates. Chapter 10 links exchange rates to systematic risk; Chapter 9 brings in the LRS limit as a regulatory constraint on overseas investment.
Common exam traps
- Home currency depreciation increases returns on foreign assets; appreciation reduces them. This is the single most tested point.
- It affects foreign-currency assets, not ordinary rupee assets held by a resident — though Chapter 3 notes exchange rates influence domestic stock markets too.
- Exchange rate risk is a component of systematic risk in Chapter 10's list of common factors — not a diversifiable company-specific risk.
- LRS is USD 2,50,000 per financial year, April to March, for all resident individuals including minors. It started at USD 25,000 in 2004.
- Currency risk is not the same as political or geopolitical risk, though geopolitical events can drive currency moves. The workbook lists them separately.
Where this is taught
- Series XXI-B · Chapter 1: Investment Landscapeintroduced here
- Series XIX-C · Chapter 1: Investments Landscapeintroduced here
- Series XIX-E · Chapter 1: Investments Landscapeintroduced here
- Series XIX-D · Chapter 1: Investments Landscapeintroduced here
- Series XXI-A · Chapter 1: Investmentsintroduced here
Related terms
- HedgingTaking a derivative position that moves opposite to an exposure you already have, so gains on one offset losses on the other and the future rate is locked in at a known level.
- Systematic riskThe part of an investment's risk that comes from economy-wide forces moving every asset at once — it cannot be diversified away, and it is the only risk the market pays you to carry.
- Liberalised Remittance SchemeThe RBI facility letting a resident individual remit up to USD 250,000 per financial year abroad for any permissible current or capital account transaction, including investment in offshore funds.
- Non-Resident IndianAn Indian citizen or person of Indian origin who does not meet the resident conditions. NRIs may invest in PMS through NRE or NRO accounts and are taxed only on Indian income.
- Geopolitical riskThe risk that international conflicts, sanctions, trade disputes or diplomatic tensions disrupt trade, supply chains and investor confidence, causing market volatility and losses.
- Cross currency swapAn OTC agreement to exchange floating-rate payments in one currency for floating-rate payments in another, with principal typically exchanged at both the start and end, used to hedge foreign-currency portfolio exposure.
- NIFTY50 USDThe dollar-linked variant of NIFTY 50: the NIFTY 50 close multiplied by the base-date exchange rate and divided by the day's exchange rate, so foreign investors see Indian equity returns in dollars.
- Base currencyThe first currency in a pair, fixed at one unit and priced in the second (quotation) currency. In USDINR the base is USD, so the quote is the rupee price of one dollar.
- Vehicle currencyA common third currency — most often the US dollar — through which two other currencies are traded, instead of trading them directly against each other.
- Bretton Woods SystemThe 1944–1971 exchange rate system in which currencies were pegged to the US dollar within ±1% and the dollar was pegged to gold; it collapsed by 1973, giving way to floating rates.
- Currency swapAn OTC derivative in which two parties exchange streams of interest payments and/or principal in different currencies on set dates over the swap's life, at an exchange rate agreed at the start.
- Telegraphic Transfer buying rateThe State Bank of India's telegraphic transfer buying rate for a foreign currency — the rate the Income Tax rules use to convert foreign-currency capital gains and income from securities into rupees.
- Gold standardThe system, dating from around 1870, under which a central bank held gold against its paper currency, so the rate between any two currencies followed from their gold prices instead of from trading.
- Fiat moneyGovernment-issued currency that is not backed by a physical commodity such as gold or silver; its value rests on supply and demand and on the stability of the issuing government.
- Clean floatAn exchange rate regime in which a currency's value is set purely by supply and demand in the market, with no government rule or central bank action affecting its price.
- Carry tradeBorrowing in a currency with low interest rates and investing the money in assets of a currency with high interest rates, to earn the interest rate differential.
- Reasons for not investing overseasThe five reasons the workbook gives, beyond simple unfamiliarity, why Indian investors under-invest in overseas securities — lack of knowledge, legal restrictions, cost of access, tax conflicts and lack of expert advice.
- International assetsShares listed outside India, bonds in other currencies or real estate abroad — investments that carry the asset's own risk plus the effect of exchange-rate movements against the rupee.
- Base and quoting currencyIn a currency pair like USD/INR, the first currency is the base currency and the second is the quoting currency — the rate shows units of the quoting currency per one unit of the base currency.