Causes of foreign exchange rate fluctuations: speculation

International Trade and Globalisation – Foreign Exchange Rates

Objective

Understand the causes of foreign exchange rate fluctuations, with a focus on the role of speculation.

1. What is a Foreign Exchange Rate?

A foreign exchange rate (or simply exchange rate) is the price of one currency expressed in terms of another currency. It tells us how many units of the foreign currency can be bought with one unit of the domestic currency.

2. Why Do Exchange Rates Change?

Exchange rates are not fixed; they move in response to a range of economic forces. The main causes include:

• Changes in relative inflation rates
• Differences in interest rates
• Changes in economic growth and productivity
• Government intervention (e.g., buying or selling foreign reserves)
• Speculation

3. Speculation Defined

Speculation is the act of buying or selling a currency with the expectation that its value will change in the near future, allowing the trader to profit from the price movement.

Speculators are typically large financial institutions, hedge funds, or individual traders who operate in the foreign exchange (Forex) market.

4. How Speculation Affects Exchange Rates

Speculators influence exchange rates through the following mechanisms:

1. Expectations of Future Movements – If traders expect a currency to appreciate, they will buy that currency now, increasing demand and pushing the price up.
2. Self‑fulfilling Prophecies – The collective actions of many speculators can cause the very movement they anticipate, even if underlying fundamentals have not changed.
3. Liquidity Provision – Speculators add volume to the market, making it easier for other participants (importers, exporters, tourists) to exchange currencies.
4. Rapid Reversal – If expectations change, speculators may quickly sell the currency, causing a sharp depreciation.

5. Example: Speculative Attack on a Currency

Consider a scenario where investors believe that Country A’s central bank will be forced to devalue its currency because of low foreign reserves.

The steps might be:

1. Speculators start buying foreign currency (e.g., USD) and selling Country A’s currency (e.g., A‑Dollar).
2. Increased demand for USD and excess supply of A‑Dollar cause the A‑Dollar to depreciate.
3. The central bank may intervene by selling its foreign reserves to support the A‑Dollar, but reserves are limited.
4. If reserves run out, the central bank is forced to devalue, confirming the speculators’ original expectation.

6. The Role of Interest Rate Differentials

Speculators often use the “carry trade” strategy, borrowing in a low‑interest‑rate currency and investing in a high‑interest‑rate currency. The profit equation can be expressed as:

\$\text{Carry Trade Profit} = (i{\text{high}} - i{\text{low}}) - \Delta e\$

where \$i{\text{high}}\$ and \$i{\text{low}}\$ are the interest rates of the high‑ and low‑interest‑rate currencies, and \$\Delta e\$ is the change in the exchange rate during the holding period.

7. Potential Benefits and Risks of Speculation

8. Government and Central Bank Responses

When speculation threatens to destabilise a currency, authorities may:

• Intervene directly in the Forex market (buying or selling reserves).
• Raise or lower interest rates to make the currency more or less attractive.
• Implement capital controls to limit the flow of speculative capital.
• Communicate policy intentions clearly to manage expectations.

9. Summary Checklist

• Speculation is driven by expectations of future exchange‑rate movements.
• Speculators can cause both appreciation and depreciation through buying or selling pressure.
• Self‑fulfilling expectations can lead to rapid and large exchange‑rate changes.
• Interest‑rate differentials are a key factor in speculative strategies such as the carry trade.
• Governments may intervene to stabilise the currency, but interventions can be costly.