Reasons for buying and selling foreign currencies: speculation
International Trade & Globalisation – Foreign‑Exchange Rates (IGCSE 6.3)
Learning objectives
- Define a foreign‑exchange (FX) rate and understand quoting conventions.
- Identify the three main reasons for buying and selling foreign currencies: trade, investment and speculation.
- Explain how a floating exchange rate is determined by demand and supply.
- Analyse the factors that shift the demand or supply for a currency.
- Describe the economic consequences of exchange‑rate movements.
- Outline the main government tools that can influence the FX market.
- Understand the role of speculators, how they trade and the risks involved.
1. What is a foreign‑exchange rate?
- Definition: The price of one unit of a currency expressed in terms of another currency. It tells us how many units of the quote (or “foreign”) currency are required to buy one unit of the base (or “home”) currency.
- Quoting conventions
- Direct quote – home‑currency per unit of foreign currency (e.g. $1.30/£ in the UK).
- Indirect quote – foreign‑currency per unit of home currency (e.g. £0.77/$ in the US).
- Floating (flexible) exchange rate: The rate is set by the market – the interaction of demand and supply for the currency – without a legally fixed parity.
2. Why do people buy and sell foreign currencies?
| Reason | Typical participants | Purpose of the transaction |
|---|---|---|
| Trade‑related transactions | Importers, exporters, retailers, travel agencies | Pay for imports or receive payment for exports; convert foreign earnings back into the home currency. |
| Investment / portfolio flows | Companies, individuals, pension funds, sovereign wealth funds | Buy foreign assets (stocks, bonds, property) or repatriate dividends, interest and profits. |
| Speculation | Traders, hedge funds, banks, private investors | Buy or sell a currency expecting its value to move in a direction that yields a profit. |
3. How is a floating exchange rate determined?
In a floating system the exchange rate is the price at which the quantity of a currency demanded equals the quantity supplied. The diagram below represents the market for a foreign currency.
3.1 Factors that shift the demand curve (increase demand = appreciation)
- Higher domestic interest rates – attract foreign capital (higher return on domestic assets).
- Positive expectations about the domestic economy – strong GDP growth, low unemployment, political stability.
- Current‑account surplus – foreigners need the domestic currency to buy exports.
- Anticipated appreciation – speculative buying based on expected future gains.
3.2 Factors that shift the supply curve (increase supply = depreciation)
- Higher foreign interest rates – make foreign assets more attractive.
- Higher domestic inflation – erodes purchasing power, reducing demand for the currency.
- Current‑account deficit – domestic residents need foreign currency to pay for imports.
- Negative expectations – political unrest, policy uncertainty, or expected depreciation.
4. Consequences of exchange‑rate movements
| Effect | When the home currency depreciates | When the home currency appreciates |
|---|---|---|
| Exports | Become cheaper for foreign buyers → tend to rise. | Become more expensive → tend to fall. |
| Imports | Become more expensive → tend to fall. | Become cheaper → tend to rise. |
| Inflation | Import‑price inflation pushes the CPI up. | Cheaper imports help contain inflation. |
| Tourism | Inbound tourism rises (foreign visitors get more value); outbound travel falls. | Outbound tourism becomes cheaper; inbound tourism falls. |
| Balance of payments | Current‑account improves (more exports, fewer imports); capital account may weaken. | Current‑account deteriorates; capital account may strengthen. |
5. Government policies that can affect the FX market
| Policy tool | Mechanism | Typical aim |
|---|---|---|
| Central‑bank intervention (buying/selling reserves) | Directly changes supply or demand for the domestic currency. | Stabilise excessive volatility or steer the rate in a desired direction. |
| Interest‑rate policy (changing the policy rate) | Alters the return on domestic assets, influencing capital flows. | Strengthen (raise rates) or weaken (cut rates) the currency. |
| Capital controls (taxes, limits, reporting requirements) | Restricts the amount of foreign currency that can be bought, sold or moved abroad. | Reduce speculative pressure, protect reserves, or manage capital flight. |
| Exchange‑rate regime change (peg → float or vice‑versa) | Alters the legal framework that determines how the rate is set. | Give the market more freedom (float) or provide stability (peg). |
6. Speculation – detailed view
6.1 What motivates speculators?
- Expectation that a currency will appreciate (price rise) or depreciate (price fall).
- Desire to profit from short‑term movements rather than from underlying trade or investment needs.
- Opportunity to exploit differences between spot and forward markets (e.g., the “carry trade”).
- Providing liquidity – large speculative volumes make the market deeper for all participants.
6.2 Typical steps in a speculative transaction
- Gather information that could affect the currency (interest‑rate announcements, GDP data, elections, geopolitical events).
- Form a view: Will the currency appreciate or depreciate?
- Enter the market
- Buy the currency if you expect appreciation.
- Sell (or sell short) the currency if you expect depreciation.
- 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.
6.3 Simple profit example
Assume a speculator buys £1,000,000 when the spot rate is \$1.30/£ and sells when the rate rises to \$1.35/£.
\[
\text{Profit}= (S{\text{sell}}-S{\text{buy}})\times Q
= (1.35-1.30)\times 1{,}000{,}000
= \$50{,}000
\]
where Sbuy and Ssell are the buying and selling exchange rates and Q is the quantity of foreign currency.
6.4 How speculation moves the market
| Scenario | Speculative action | Effect on demand for the currency | Resulting exchange‑rate movement |
|---|---|---|---|
| Strong domestic economic data released | Buy the domestic currency | Demand increases | Appreciation |
| Political instability forecast | Sell the domestic currency | Demand decreases | Depreciation |
| Domestic interest rate rises relative to foreign rates | Enter a carry‑trade (borrow in low‑rate currency, buy high‑rate currency) | Demand for high‑rate currency increases | Appreciation of the high‑rate currency |
6.5 Risks faced by speculators
- Exchange‑rate risk: Adverse moves can generate losses larger than the initial outlay.
- Leverage risk: Using borrowed funds magnifies both gains and losses; a small adverse move can wipe out equity.
- Liquidity risk: In stressed markets it may be difficult to close a position at the desired price.
- Regulatory risk: New capital controls, transaction taxes or changes in market‑access rules can affect profitability.
7. Key points to remember (exam revision)
- A foreign‑exchange rate is the price of one currency in terms of another; the IGCSE assumes a floating regime.
- Three main motives for FX transactions: trade, investment and speculation.
- In a floating system the rate is set where the quantity of a currency demanded equals the quantity supplied.
- Demand and supply are shifted by interest‑rate differentials, inflation differentials, current‑account balances, expectations and overall economic performance.
- Depreciation makes exports cheaper and imports more expensive; appreciation has the opposite effect and also influences inflation, tourism and the balance of payments.
- Governments can intervene through central‑bank actions, interest‑rate policy, capital controls or by changing the exchange‑rate regime.
- Speculators seek profit from expected short‑term movements; their activity can increase volatility but also adds liquidity to the market.
- Understanding the macro‑economic indicators that move exchange rates is essential for traders, investors and policy‑makers alike.