Currency Speculators Essay

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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:   

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

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