International Trade and Globalisation – Foreign Exchange Rates
Objective: Reasons for buying and selling foreign currencies – Speculation
Speculation is the purchase or sale of a foreign currency with the expectation that its value will change in the trader’s favour, allowing a profit to be made. It is distinct from trade‑related transactions (imports/exports) and from hedging, which is undertaken to reduce risk.
Why do speculators buy and sell foreign currencies?
Anticipation of a change in the exchange rate due to economic news, political events or market sentiment.
Desire to profit from short‑term movements rather than long‑term fundamentals.
Opportunity to exploit differences between spot rates and forward rates (carry trade).
Liquidity provision – speculators increase market depth, making it easier for others to trade.
How speculation works – a step‑by‑step outline
Analyse information that could affect a currency’s value (e.g., interest‑rate changes, GDP data, elections).
Form a view: the currency will either appreciate or depreciate.
Enter the market:
Buy the currency if you expect it to appreciate.
Sell the currency (or sell short) if you expect it to depreciate.
Monitor the exchange rate movement.
Close the position:
Sell the currency you bought if it has risen.
Buy back the currency you sold if it has fallen.
Calculate profit or loss.
Simple profit calculation
If a speculator buys £1,000,000 when the spot rate is \$1.30/£ and sells when the rate rises to \$1.35/£, the profit is:
where \$S{\text{buy}}\$ and \$S{\text{sell}}\$ are the buying and selling exchange rates, and \$Q\$ is the quantity of foreign currency.
Impact of speculation on exchange rates
Speculative activity can cause short‑term fluctuations in exchange rates, even when underlying economic fundamentals are unchanged. Large volumes of speculative buying push the demand curve for a currency to the right, leading to an appreciation; large volumes of selling push it to the left, causing depreciation.
Scenario
Speculative Action
Effect on Demand for Currency
Resulting Exchange‑Rate Movement
Positive economic news expected
Buy the currency
Demand increases
Currency appreciates
Political instability expected
Sell the currency
Demand decreases
Currency depreciates
Interest‑rate differential widens in favour of the currency
Buy the currency (carry trade)
Demand increases
Currency appreciates
Suggested diagram: Supply‑and‑demand curves for a foreign currency showing how speculative buying shifts the demand curve to the right, leading to an appreciation of the currency.
Risks associated with speculation
Exchange‑rate risk: If the market moves opposite to expectations, losses can exceed the initial outlay.
Leverage risk: Many speculators use borrowed funds; small adverse moves can wipe out equity.
Liquidity risk: In volatile periods, it may be difficult to close a position at the desired price.
Regulatory risk: Changes in capital controls or transaction taxes can affect profitability.
Key points to remember
Speculation is driven by expectations of future exchange‑rate movements, not by the need to pay for goods or services.
Speculators can profit from both rising and falling currencies.
Large speculative flows can amplify short‑term exchange‑rate volatility.
Understanding the macro‑economic indicators that influence currency values is essential for successful speculation.