Currency Conversion

When humans started growing, expanding, socialising and organising themselves and their surroundings, they found it hard for just one family to take on all tasks for the entire tribe or group. We took up jobs such as caretakers, leaders, farmers and hunters which were needed to collectively keep a group running. Through this, the need to exchange products came into existence and the system worked.

But, as we now know, trading based on the exchange of two items is inefficient. This is why currency was introduced, an object imbued with value such that the wants on one side became uniform. With this, slowly every country developed their own currency unique to its own culture and/or history.

With the boom in international trade, another need was established, the conversion of one region’s currency into another's. Today, the majority of the world uses the floating exchange rate system where the currency(or floating currency) is based on the foreign exchange market.

These exchange rates are determined by the force of supply and demand. Basically, however much demand is present for one currency, its value increases with regard to another one.

Other influences would be inflation rates(increase in prices of a country's goods), unemployment rates, gross domestic product(total value of finished goods and services) and interest rate charges to name a few. A more restricted version of this exchange rate would be the pegged exchange rate. Here, a country ties its own currency at a fixed rate to another’s. So as the latter’s value changes, the former will be adjusted accordingly.

How is this useful in investment practices? This knowledge comes into direct application, especially in today’s times, in the realm of foreign investment.

Currently, 1 USD is 79.78 INR. In an American investor's eyes, this is quite unfortunate because even if they do invest less, their earnings would also be less as the rate of conversion of INR to USD is too high. Considering the high inflation rates occurring in America which drops the value of the dollar, pouring money into Indian companies is not desirable when there is no apparent profit. This is because by converting the INR returns to USD the value obtained will be very less leading to seemingly no profit.

If the said American investor bought stock without understanding the implications of the currency conversion rates, he would be facing big losses. The converse is true for an Indian investor as the amount of money he would have to put in for a good investment would be too high.

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Author

Govind Menon