What Do You Mean By Exchange Rate Risk?
Exchange rate risk is incurred due to changes in the exchange rate of domestic currency relative to a foreign currency. When a domestic investor invests in foreign assets, or a foreign investor invests in domestic assets, the investment of HNI traders is subject to exchange rate risk.
It must be noted that:
If domestic currency depreciates (falls in value) against foreign currency, the value of foreign asset goes up in terms of domestic currency and the value of domestic assets in terms of foreign currency goes down.
If domestic currency appreciates (increase in value) against foreign currency, the value of foreign asset goes down in terms of domestic currency and the value of the domestic assets in terms of foreign currency goes up.
Consider this example. An NRI based in the US invests $1000 in a bank deposit in India at10% for 1 year when the exchange rate is Rs. 60 per US$. After one year, the rupee depreciates and the exchange rate is Rs. 67 per US$. What is the risk to his investment if he decides to repatriate the money back?
The value of his investment has increased in rupee terms and declined in dollar terms as the rupee has depreciated against the dollar.
Initial Invested amount = US$1000 = Rs.60000
Interest earned = 10% x 60,000 = Rs. 6000
Investment value after one year = 60000+6000 = Rs. 66000
Investment value in dollar terms = 66000/67 = $985
Loss in investment value = $1,000 - $985 = $15
Although the deposit paid a nominal return of 10%, there was a loss in investment value, because the exchange rate depreciated by more than 10%.
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