What decides a currency's exchange rate
The answer
An exchange rate is the price of one currency in another, set by everybody buying and selling them. Over decades it tracks the difference in inflation between the 2 countries. Over months it is driven by the difference in interest rates and by money moving in and out. Over days it is driven by news and by positioning.
Why this costs you money
A currency move is not one event. It is a transfer between the companies you own.
When the rupee falls against the dollar, an Indian software services company earning dollars and paying salaries in rupees receives more rupees for the same contract. Its profit rises for no operational reason. On the same day, an airline paying for fuel priced in dollars, or a chemicals company importing raw material, pays more rupees for the same input. Its profit falls for no operational reason.
Both are in most Indian portfolios, and most holders treat the whole day as "the rupee crashed, markets are down".
Here is the specific loss. A reader sees the currency headline, sees a red screen, and sells the position that was being helped. Months later, when the currency reverses, they sell the other one. Two decisions, both backwards, because the direction of the effect was never checked.
It takes 5 minutes to know which of your holdings is on which side.
How it works
Five forces set an exchange rate. They operate on completely different time scales, which is why explanations that mix them are confusing.
1. Trade flows. An exporter receives foreign currency and converts it, creating demand for the local currency. An importer does the reverse. A country importing more than it exports has steady downward pressure on its currency.
2. Capital flows. Money moving in and out for investment. These flows are much larger and much faster than trade flows. A foreign investor buying Indian shares must first buy rupees.
3. Interest rate differences. If one country pays 5% and another pays 2%, money moves toward the higher rate. This is why an exchange rate can move sharply on a policy decision taken in a different country.
4. Inflation differences. If prices in Country A rise 6% a year and prices in Country B rise 2%, then over time A's currency must fall about 4% a year against B's. This is the long-run anchor. It explains almost nothing about this month and most of what has happened over 20 years.
5. Expectations and risk appetite. When investors become frightened, money moves to the currencies they consider safest, mainly the dollar. This can move a currency against everything the other 4 forces suggest, for weeks.
The regimes
| Regime | How it works | Example |
|---|---|---|
| Free float | The market sets it; the central bank does not intervene | US dollar |
| Managed float | The market sets it; the central bank smooths moves | Indian rupee |
| Peg | The central bank commits to a rate or band and defends it | Gulf currencies |
| Currency board | Every unit issued is backed by a foreign reserve | Hong Kong dollar |
A managed float means the central bank does not target a level, but does act against disorderly movement. So there is no line the RBI is defending and no level it can be forced away from.
How intervention actually works
To support the rupee, the RBI sells dollars from its reserves and buys rupees. Reserves fall, and rupees are removed from the banking system, which tightens domestic liquidity. Supporting the currency is therefore also a tightening of monetary conditions, intended or not. To stop the rupee rising it does the reverse, buying dollars with newly created rupees.
This is why the exchange rate and the interest rate cannot be managed independently while capital moves freely. A country can control any 2 of: the exchange rate, domestic monetary policy, and free capital movement. Not all 3. India's capital controls are the direct consequence of wanting the first 2.
The dollar index
The DXY measures the dollar against 6 currencies: the euro at about 57.6%, the yen 13.6%, the pound 11.9%, the Canadian dollar 9.1%, the Swedish krona 4.2% and the Swiss franc 3.6%. It was created in 1973 at a base value of 100, and its composition has changed once, in 1999, when the euro replaced 5 European currencies.
Note what is not in it: the rupee, the renminbi, the Mexican peso, the Korean won. "The dollar is strong" according to the DXY can be almost entirely a statement about the euro. The Federal Reserve publishes broader trade-weighted measures for exactly this reason.
What it tells you, and what it does not
A falling currency is not a verdict on a country. It is mostly the accumulated inflation difference. A country growing faster than another can have a currency that falls against it every year for 30 years.
It does not tell you a market will fall. A weaker currency raises the local currency value of foreign earnings, which can support an equity index even as it raises import costs.
Purchasing power parity does not work over short periods. Currencies deviate from it for a decade at a time.
Reserves are not a target. A central bank with large reserves is not more likely to defend a level. It is more able to smooth a move. Those are different things.
The decision rule
For every company you own, answer 2 questions.
Where is the revenue earned? Where are the costs incurred?
If revenue is in a foreign currency and costs are local, a weaker local currency helps. If revenue is local and a major input is imported, a weaker local currency hurts. If both are local, the direct effect is close to zero.
Then add the third category most people forget: foreign currency debt. A company that borrowed in dollars and earns in rupees is hurt twice by a falling rupee — the interest costs more and the principal grows in rupee terms.
Try this now
Five minutes on your own holdings.
- For each company, find the revenue by geography figure. It is in the annual report under segment information, and most screener websites show an export or overseas revenue percentage.
- Sort each holding into 1 of 4 columns: Exporter — most revenue in foreign currency, most costs local. Importer — revenue local, a major input imported. Domestic — both local. Foreign currency borrower — significant debt in a currency it does not earn.
- For the fourth column, check the annual report for unhedged foreign currency exposure. Companies are required to disclose it. If the number is large relative to profit, that is your largest single currency risk.
- Add up the value of your holdings in each column.
- Write one sentence: "If my currency falls 5%, my portfolio is helped by ___% of it and hurt by ___% of it."
What you should see. Most Indian portfolios turn out to be more balanced than their owners believed, because information technology and pharmaceutical companies sit on one side and energy, aviation and chemicals sit on the other.
The number that usually surprises people is in step 3. Unhedged foreign currency debt is disclosed, rarely read, and is the exposure that turns a currency move from a profit effect into a solvency question.
Do this once and the next currency headline becomes a calculation you have already done.
Three real cases
1. The taper tantrum, 22 May to 28 August 2013 (India) — a decision taken elsewhere On 22 May 2013 the US Federal Reserve chairman suggested the Fed might slow its bond purchases. Nothing changed in India. Money nonetheless left emerging markets for dollar assets. The rupee fell through the summer and hit a record low of 68.85 to the dollar on 28 August 2013, losing 3.7% in that single session. The RBI responded by tightening domestic liquidity, raising the marginal standing facility rate and restricting gold imports. The trigger was a sentence spoken in Washington about American policy, and the effect landed on the rupee cost of Indian oil.
2. The United Kingdom, 16 September 1992 — a fixed rate meets a market Sterling was in the European Exchange Rate Mechanism, committed to a band against the German mark. Traders judged the rate too high for British conditions and sold. The Bank of England bought sterling and raised its interest rate from 10% to 12%, then announced a further rise to 15% on the same day. It was not enough. That evening Britain left the mechanism and sterling floated down. A central bank with reserves, legal authority and the willingness to raise rates 5 percentage points in a day could not hold a price the market disagreed with. That is the practical limit of intervention.
3. The dollar's rise, 2022 — the interest rate channel, in the open As the Federal Reserve raised rates from near zero through 2022 while other central banks moved more slowly, the interest rate difference widened in the dollar's favour and the dollar rose broadly. The rupee crossed 80 to the dollar for the first time in July 2022. The yen and the pound also fell sharply in the same period. Nothing had changed in Japan, Britain or India to cause this. The change was in the return available on holding dollars.
The question that resolves it
A novice sees a currency headline and asks: is this good or bad?
An expert asks: good or bad for whom, in my own holdings?
There is no answer to the first question. A currency move is a transfer, and somebody is on each side of it. The only version with an answer is the one about a specific balance sheet, and the first balance sheet to ask about is your own.
What would make this wrong
If exchange rates were driven mainly by trade flows, countries with large trade surpluses would have steadily rising currencies and countries with deficits steadily falling ones. The relationship is far weaker than that. Capital flows are larger and faster, which is why an exchange rate can move against the trade position for years.
Three limits. Nobody forecasts exchange rates well — over horizons under a year, professional forecasts do poorly against simply assuming today's rate. The 5 forces conflict: when a country's inflation is high, which pushes its currency down, and its interest rates are high, which pulls it up, the framework does not tell you which wins. And company effects are not as clean as the columns suggest, because exporters hedge, importers pass costs on and contracts are re-priced. The sorting exercise gives you the direction of the first effect, not the size of the final one.
In India
The rupee operates on a managed float. The RBI's stated position is that it does not target a level or a band, and intervenes only to contain excessive volatility. It acts in the spot market and also through forwards, which is why the size of the RBI's forward book is worth watching alongside its headline reserves.
Capital controls are the defining feature. Foreign portfolio investors operate under registration and limits. Resident individuals may remit up to $250,000 per financial year under the Liberalised Remittance Scheme. Indian companies borrowing abroad do so under the External Commercial Borrowings framework, with caps on amount, cost and end use.
The structural pressure is downward. India runs a trade deficit in most years, driven by crude oil and gold imports, and domestic inflation is higher than in the United States. So the base case for USD/INR has been a gradual rise, interrupted by sharp episodes when capital leaves. USD/INR is around 95 as of the most recent data, having reached an all-time high near 99.8 earlier in 2026 .
In the United States
The dollar floats freely. The Federal Reserve does not intervene in normal conditions. Exchange rate policy is formally the Treasury's responsibility, with the Fed acting as its agent on the rare occasions intervention occurs.
The dollar's level is largely a consequence of 2 things: the interest rate the Fed sets relative to other central banks, and global risk appetite. When investors become frightened about anything, anywhere, they buy dollars. This produces the counterintuitive result that the dollar frequently rises on bad news about the United States.
Two measures are quoted. The DXY covers 6 developed currencies and is dominated by the euro. The Federal Reserve's broad trade-weighted dollar index covers a much wider set of trading partners including China, Mexico and India, and is the better measure of the dollar's effect on world trade.
A stronger dollar tightens conditions worldwide, because a large volume of debt outside the United States is denominated in dollars. This is the mechanism by which a Fed decision reaches a company in Mumbai that has never sold anything in America.
Where they differ, and what that tells you
The rupee is a managed float with capital controls. The dollar is a free float with none. That is the whole difference and everything else follows from it.
For an Indian investor there are 3 consequences.
Volatility is suppressed until it is not. RBI smoothing means the rupee moves less than an unmanaged currency most of the time, and then moves a great deal in short episodes when the pressure exceeds what smoothing can absorb. 2013 and 2022 are both examples. Do not read low realised volatility as low risk.
The direction is asymmetric. An American investor faces a currency that moves in both directions around no trend. An Indian investor faces one with a downward trend against the dollar. Plans should be built accordingly.
Global events reach India twice. A Fed tightening pulls capital out of Indian markets and simultaneously raises the rupee cost of imported oil. An American investor feels the first effect only.
The one thing identical in both countries is the exercise in this article. Sort your holdings by where they earn and where they spend. That works the same way in Mumbai and in New York.
Carry this
- An exchange rate is a price. Over decades, inflation differences. Over months, interest rate differences. Over days, fear.
- A currency move is a transfer between your own holdings, not a single event.
- Foreign currency debt is the exposure that turns a profit effect into a solvency problem.