What is currency risk in international stock investing?

Currency risk, also known as exchange rate risk, refers to the potential for financial losses due to fluctuations in currency exchange rates. When you invest in international stocks, your returns may be affected by changes in the value of the foreign currency relative to your home currency. For example, if you are investing in a stock from the US while based in India, a weakening US dollar compared to the Indian rupee could reduce the value of your investment returns when converted back to your home currency. Conversely, if the foreign currency strengthens, your returns could increase.

1. What is Currency Risk?

Currency risk occurs when changes in currency exchange rates affect the value of your international investments. This risk is inherent in any investment made outside of your home country because the value of a foreign stock can be influenced by fluctuations in the currency exchange rate. For example, if the foreign currency weakens compared to your home currency, the returns you get from your investment may be less than expected when converted into your home currency.

For Indian investors, currency risk means that their returns from international stocks could be significantly impacted by changes in the exchange rate between the Indian Rupee (INR) and the currency of the country in which they have invested.

2. How Does Currency Risk Affect International Stock Investments?

When you invest in foreign stocks, your returns are not just influenced by the performance of the company or the stock market, but also by fluctuations in exchange rates. If the currency of the country where your investment is located appreciates (strengthens) against your home currency, your investment may increase in value when converted back to your currency. However, if the foreign currency depreciates (weakens), the value of your investment could decrease.

• Example 1: If you invest in a US-based company and the US dollar strengthens against the Indian Rupee, your returns, when converted back to INR, will be higher.
• Example 2: If the US dollar weakens against the Indian Rupee, your returns will be lower when you convert them back to INR, even if the stock price itself increases in the foreign market.

3. Examples of Currency Risk Impact

Let’s take some real-life examples to understand how currency risk can impact investments:

• Example 1: Investing in US Stocks from India - Suppose you invest in a US-based technology company. If the US dollar strengthens against the Indian Rupee (INR), the value of your investment will rise when converted back to INR. But if the US dollar weakens against the INR, you could lose money even if the stock price has risen in USD.
• Example 2: Investing in European Stocks - If you invest in European stocks while based in India and the Euro weakens against the INR, you could face a situation where your returns decrease when converted back into INR, even though the stock might have done well in the European market.

4. How to Manage Currency Risk in International Stock Investments?

Managing currency risk in international investments can be tricky, but there are several strategies you can use to mitigate it:

• Hedging Currency Risk: One strategy is to hedge currency risk using financial instruments like currency futures or options. This helps protect your investment from unfavorable changes in exchange rates.
• Investing in Hedged ETFs: Another option is to invest in exchange-traded funds (ETFs) that hedge against currency risk, which means the ETF automatically takes measures to protect against fluctuations in the foreign exchange rate.
• Diversification: By diversifying your international investments across different countries and regions, you reduce the risk of any single currency fluctuation affecting your entire portfolio.

5. Why is Currency Risk Important for Indian Investors?

For Indian investors, currency risk is especially relevant because fluctuations in the Indian Rupee (INR) against global currencies can have a significant impact on the returns from international investments. With the INR often experiencing volatility against major currencies like the US Dollar, Euro, or Japanese Yen, Indian investors must be aware of the potential impact on their investment returns, both in terms of gains and losses.

• Exchange Rate Volatility: Currency fluctuations can lead to unpredictable returns for Indian investors, especially in markets where the INR is weaker.
• Global Diversification: While international stocks provide diversification benefits, currency risk must be carefully considered to ensure optimal returns.

6. Conclusion

Currency risk is a crucial factor to consider for Indian investors looking to diversify their portfolios with international stocks. While currency fluctuations can affect the value of your investments, employing strategies like diversification, hedging, and choosing hedged ETFs can help minimize this risk. Understanding how currency risk works and how it impacts your investment returns can help you make more informed decisions when investing in international markets.