Causes of foreign exchange rate fluctuations: speculation

International Trade and Globalisation – Foreign Exchange Rates

Objective

To understand why foreign‑exchange (FX) rates move, the role of speculation, and the consequences for an economy.

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.

In the Cambridge IGCSE syllabus (0455) only floating exchange rates are examined – rates are determined by market forces, not by a government‑set fixed parity.

2. Why Do People Buy or Sell Foreign Currencies?

The syllabus lists four main motives, plus two additional common motives that appear in exam questions.

These motives generate the supply and demand that determine the exchange rate in the foreign‑exchange market.

3. How are Floating Exchange Rates Determined?

In a floating‑rate system the exchange rate is the price at which the quantity of a currency demanded equals the quantity supplied – the market equilibrium.

3.1 Supply‑and‑demand diagram (conceptual)

• Demand for a currency comes from:

  • Foreign buyers of the country’s goods, services and assets
  • Speculators who expect the currency to rise
  • Investors seeking profit, interest or dividends

• Supply of a currency comes from:

  • Domestic buyers of foreign goods, services and assets
  • Speculators who expect the currency to fall
  • Central‑bank sales of foreign‑exchange reserves

When demand > supply the currency appreciates (price rises).

When supply > demand the currency depreciates (price falls).

3.2 Factors that shift the curves (syllabus terminology)

• Interest‑rate differentials – higher domestic rates attract foreign capital → demand for domestic currency rises.
• Relative inflation rates – lower domestic inflation makes goods cheaper abroad → export demand rises → demand for domestic currency rises.
• Expectations of future movements – news, political events or policy hints cause traders to buy or sell in advance.
• Economic growth & productivity – stronger growth raises expected returns on assets → demand for domestic currency rises.

3.3 Key terms to remember

• Floating exchange rate – rate set by market forces.
• Appreciation – the currency becomes more expensive (its price in foreign currency rises).
• Depreciation – the currency becomes cheaper (its price in foreign currency falls).
• Equilibrium exchange rate – the price where supply equals demand.

4. Speculation

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 usually large financial institutions, hedge funds, or individual traders operating in the Forex market.

4.1 How Speculation Affects Exchange Rates

1. Expectation‑driven demand shifts – If traders expect a currency to appreciate, they buy it now, increasing demand and pushing the rate up.
2. Self‑fulfilling movements – The collective buying (or selling) can create the very appreciation (or depreciation) that was expected, even when underlying fundamentals have not changed.

4.2 Consequences of Speculative Activity

• Liquidity provision – Speculation adds volume, making it easier for businesses and tourists to exchange currencies.
• Potential for rapid reversal – A change in expectations can cause many speculators to sell at once, leading to a sharp depreciation.

5. Extension Topics (Optional – not examined)

5.1 Speculative Attack – a case study

When investors believe a central bank’s reserves are insufficient to defend the currency, they may sell that currency en masse. The resulting pressure can force the bank to devalue, confirming the original speculation. This example illustrates the power of coordinated speculative expectations.

5.2 The Carry Trade

A common speculative strategy is to borrow in a low‑interest‑rate currency and invest in a high‑interest‑rate currency. The profit formula is:

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

where i_high and i_low are the respective interest rates and Δe is the change in the exchange rate during the holding period.

6. Consequences of Exchange‑Rate Movements for the Economy

• Export competitiveness – Depreciation makes exports cheaper for foreign buyers, potentially increasing export volumes.
• Import prices & domestic inflation – Appreciation lowers import costs, helping to contain inflation; depreciation raises import prices and can feed into higher consumer prices.
• Tourism – A weaker currency makes the country cheaper for foreign tourists (boosting receipts); a stronger currency can deter visitors.
• Foreign investment – Higher expected returns (e.g., from interest‑rate differentials) attract portfolio inflows, while exchange‑rate uncertainty can deter long‑term investment.

7. Benefits and Risks of Speculation

8. Government and Central‑Bank Responses to Speculative Pressure

• Direct intervention – buying or selling reserves to influence the rate.
• Adjusting interest rates – making the currency more or less attractive.
• Capital controls – limiting the flow of speculative capital.
• Forward guidance – clear communication to shape market expectations.

9. Summary Checklist

• Exchange rate = price of one currency in terms of another; only floating rates are covered.
• People buy/sell foreign currency for trade, speculation, government/central‑bank action, investment returns, and remittances.
• Rate is set where supply = demand; shifts are caused by interest‑rate differentials, relative inflation, expectations, and economic growth.
• Appreciation = currency becomes more expensive; depreciation = currency becomes cheaper.
• Speculation moves rates through expectation‑driven demand shifts and self‑fulfilling movements.
• Changes in the rate affect export competitiveness, import prices, tourism, and foreign investment.
• Governments can intervene, but interventions may be costly and temporary if fundamentals are weak.