Currency Speculators Essay ⋆ Business Essay Examples ⋆ EssayEmpire

A currency speculator is an individual who trades in the foreign exchange market with the sole purpose of making a profit. For example, if the British pound is falling relative to the U.S. dollar, currency speculators will sell pounds, expecting to buy them back again sometime in the near future at a lower price.

This implies that speculators will have an uncovered “open position,” which can be difficult to cover if the pound does not fall relative to the U.S. dollar. Currency speculators are willing to take this exchange rate risk when they believe that exchange rates will move to their benefit.

In general, currency speculators trade either on the spot market and/or on the derivatives market. In the first case, a speculator will sell on the spot price if he believes that the asset is overvalued and then wait to buy back the asset in the future when he thinks that the price has fallen by so much that it will generate him a profit after all transaction costs have been paid. In the second case, currency speculators will sell the overvalued currency at the spot market and at the same time they will buy the future price of the same currency. The future price of currencies is traded in the derivatives markets and can be in the form of a forward, a future, or an option contract. In most cases, the currency speculator will “short sell” the asset, that is, she will sell an asset that she does not own hoping to buy it back in the future at a lower value.

The advantage of selling and buying the asset simultaneously is that the potential profit that can be derived from this strategy is secured. However, the downside is that by buying the asset for future delivery the trader binds himself to the future price of the asset. In such a case, the trader discards the opportunity to get an extra profit if the spot price of the currency in the future is much lower than its price of the future contract. Also, speculators, using the purchasing power parity (PPP) rules between two or more currencies, speculate by trading on the price of one currency compared with the value with all the currencies that can be exchanged for one unit of this currency.

Currency speculators predict the future exchange rate prices by analyzing changes in value or by just bluffing about the future price of assets. When speculators analyze changes in the value of assets they do so by estimating the change in the value of assets that is caused by news about their value. For example, if the American interest rate is set at a point higher than the European Union interest rate, speculators will short sell euros as they will expect that investors will start selling euros as well in order to buy U.S. dollars that offer a greater return. The downward pressure will destabilize the euro/U.S. dollar exchange rate and speculators will earn their profits by buying back euros at a lower price. On numerous occasions speculators have been accused of deliberately selling the currency of one country in order to create downward pressure; thus their prediction of a devaluated currency becomes a self-fulfilling prophecy.

The most famous example of a currency speculator is George Soros. Soros is said to be responsible for the “Black Wednesday” when the United Kingdom was forced to withdraw the British pound from the Exchange Rate Mechanism that was designed to keep a number of currencies floating within very small margins. On September, 16, 1992, Soros sold short more than £10 million, putting enormous downward pressure the Bank of England (BoE) either to raise interest rates, so that investors will start buying pounds, or to devaluate the currency. Eventually, the BoE decided to let the currency float freely, leaving the Exchange Rate Mechanism. It is said that, on that day, Soros made more than £1 million from this speculative trade.

However, currency speculators claim that it is on their actions that markets become fully efficient. Their argument is the following; when prices are not fully efficient, i.e., prices do not reflect the true fundamental values of assets, currency speculators trade on those assets, making the prices more informative and as a result the trading prices converge with the fundamental value of assets. Had the currency speculators not traded, the asset prices would have continued to trade in prices different from their optimal. In other words, speculators argue that they help prices to trade at their true value and the absence of speculative trading will have devastating results in the long term. Nevertheless, as with any profit-motivated trader, speculators ask for greater returns in order to accept the exchange rate risk that is associated with trading currencies.

Bibliography:

Brendan Brown, Bubbles in Credit and Currency: How Hot Markets Cool Down (Palgrave Macmillan, 2008);
Copeland, Exchange Rates and International Finance (Addison-Wesley, 1994);
Eiteman, A. Stonehill, and M. Moffett, Multinational Business Finance (Addison-Wesley, 1998);
Goodhart and R. Payne, The Foreign Exchange Market: Empirical Studies with High-Frequency Data (MacMillan, 2000);
Harris, Trading and Exchanges: Market Microstructure for Practitioners (Oxford University Press, 2003);
Kathy Lien, Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves (John Wiley & Sons, 2009);
F. Radalj, “Hedgers, Speculators and Forward Markets: Evidence from Currency Markets,” Environmental Modelling and Software (v.21/9, 2006);
Pilbeam, Finance and Financial Markets (Palgrave, 2005);
Rutterford, An Introduction to the Stock Exchange Investment (Palgrave, 2007);
Valdez, An Introduction to Global Financial Markets (Palgrave, 2007).

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