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Currency speculation is a common term in the financial sector. It is an essential driver behind international transactions and thus the global economy, yet it also leaves parties prone to higher stakes. Therefore, understanding this financial term will facilitate trades and investment. This article, apart from interpreting currency speculation, will help distinguish this concept from currency trading and elaborate on how investors speculate on the forex market.
What is Currency Speculation?
Currency speculation is by definition the practice of buying and holding the foreign currency with the expectation that its value will appreciate in the near future and traders can sell that currency at a higher price to make money. In other words, when speculating on currency, traders are implicitly venturing their investments on risky trades to earn proceeds from temporary movements in the current price of that financial asset, instead of benefiting from the intrinsic value of that instrument. This is because they doubt that the currency is undervalued at present and will increase in its price.
Historically, the vast majority of foreign exchange transactions were conducted between companies or individuals for either cross-border payments or travel. Meanwhile, approximately 20% of trades were speculative with the pure purpose of greater profits. However, after various remarkable events, the global economy witnessed a reversed situation: the percentage of speculative transactions dramatically increased to around 97.5%, versus a plummet to 2.5% of real foreign exchange trades. This was commented by Bernard Lietaer at the International Forum on Globalisation (IFG) seminar on December 15th, 1997.
Motivations behind the massive surge in speculative trades started from the US President Richard Nixon’s act of unilaterally canceling the convertibility of the US dollar to gold in response to the inflation rise and a wage/price freeze. This practice also abolished the Bretton Woods system which regulated fixed exchange rates on currency pairs. Currency from a powerful economy would be valued over the unsteady and weak currency. Accordingly, the former would render exports high-priced and encourage the import of merchandise from weaker countries.
The opening shot of Richard Nixon in 1971 made traders realize variations in the currency pair’s value and then spot a good opportunity to benefit from the price fluctuations.
In the 1980s, the deregulation policies of US President Ronald Reagan and the UK Prime Minister Margaret Thatcher were issued to encourage the investment and spending of businesses and promote economic growth. Also, the introduction of the Baker Plan that was administered by the World Bank and the International Monetary Fund financially supported highly indebted nations whereas those countries implemented growth-driven structural reforms. Those strategies allowed the increased capital flows and gave more leeway for speculative trading.
In recent years, technology has shifted how the financial industry works. Foreign currency and financial markets have been digitized, thus removing the physical presence of traders to conduct transactions. This, as a result, opens more avenues for the expansion of speculative trades.
Today, most currency speculations are executed on secondary exchange markets where traders engage in direct international transactions for different purposes, hence guaranteeing liquidity on the currency market. Speculation is an important element in economics and finance, in addition to a hedge which means offsetting transactions against incurred risks, arbitrage which means exploiting the price difference between distinct financial instruments for-profits, and investment which means benefiting from possessing underlying assets for a long time.
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Benefits and Risks of Currency Speculation
When participating in any transactions, traders can choose either direct investment or speculation. This depends much on how they perceive the upcoming market trends. If the odds are stacked in their favor, they will obtain substantial benefits from such a business venture. Otherwise, it may mislead them to poor decisions, then increasing their exposure to unexpected risks and worse, driving the global economy to turmoil.
Pros: Speculative trading may bring enormous advantages to traders and the global economy.
- Ensure market liquidity
Normally, corporations or individuals get involved in currency transactions to fund their investment or pay for imported products and services. Still, not all people have such demands. The appearance of speculators has made the market busier and more lively. Inevitably, without hopes of expected profits, fewer traders engage in currency trades and render the market illiquid. The more speculators stay on the market, the more traded currencies are. This keeps foreign currencies always flowing in the market, so sustaining high market liquidity.
- Stabilize exchange rates
When there are more speculative participants in the market, it implicitly means a trader has no difficulty finding counterparties to buy and sell foreign currencies without suffering from wild price fluctuations. Besides sustaining the price of currency pairs, the larger attendance in speculative trading also reduces the bid-ask spread, hence making the market more efficient.
- Ease international transactions
The role of speculators in facilitating transnational trades has long been acknowledged. For example, an electronic component manufacturer in China exports its finished products to a UK-based client. Normally, that UK importer makes a payment in British sterlings, therefore the Chinese company must convert those sterlings to renminbi to remunerate labor costs and other expenses. To do so, the business has to find the counterparty for its currency transaction.
If traders realize positive signals from the Chinese yuan – in other words, forecast the increased value of the currency against the US dollar, they can act as speculators hoping for profit from the price movement. Thereby, the Chinese firm can carry out the transaction quickly and conveniently without spending much time finding suitable buyers.
- Encourage foreign direct investment (FDI)
FDI takes place when citizens or companies of one nation want to invest in some projects in another country. This requires them to exchange their local currency to the host currency. Likewise the given example, FDI entities can find speculators to speed up their currency transactions for their smooth operations in the foreign country. This will partly stimulate FDI activities in various countries, especially in developing regions.
Cons: Currency speculation can pose several potential threats.
Despite the optimistic scenario, speculation can turn currency transactions to financial catastrophes that lead to economic stagnation, discourage international transactions, and distort the true value of currencies.
Particularly, threats have roots in speculative strategies commonly used by traders. Conventionally, speculators apply different techniques to forecast the future price moves and minimize related risks, typically following others’ actions, which is known as the herd behavior. Moreover, speculators may have a strong bias towards certain sources of information, which results in the inaccurate analysis of possible market trends and hence adversely impacting their trading decisions.
Numerous financial experts consider speculation as nothing more than the “guessing game”. Indeed, the currency market is profoundly influenced by the domestic situations of countries and their international relations, which complicates the forecast of the currency value in the near future and impossibly ensures whether the market is looking good for traded currencies. However, various traders now lack the knowledge and experience to make precise predictions. Consequently, speculating on currency trades can get involved in some following ramifications:
- Affect the price of goods
Although speculative trading is not the sole culprit behind price exaggeration, it is closely associated with this phenomenon. When currency pairs are wrongly overvalued by word-of-mouth feedback of traders, more purchasers can be tempted to make transactions and consequently make the currency price go beyond its fundamental value. This situation may push up the price of goods traded by that overvalued currency afterward. In the worst case, residents, especially the low-income, cannot afford even daily necessities due to the exorbitantly high price.
- Confront substantial losses
As speculation is a risky business, speculators have to consider the high probability of losing a fortune when the market moves unfavorably with their expectations. Even they must face a greater risk of loss than hedgers and arbitrageurs.
Resolutions to the Speculation Issues
Response From Individuals
The analysis of market value should not be based on emotions, but rather economic indicators (i.e. unemployment rate, consumer price index or gross domestic products), price action and major events. Besides, traders should be well-equipped with complete knowledge and analytical skills of the market before engaging in any speculative trades.
Response From Governments
Governments and central banks do not often intervene in foreign exchange activities unless they recognize the price movements may harm the whole economy. Having said that, so far, politicians have enacted policies and regulations to rein back speculative trading and limit the occurrence of financial crises. The notable examples are the Bubble Act 1720 launched by the British government, the Glass-Steagall Act by the US government in 1953 or the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. Those laws functioned well in controlling repercussions induced by speculation during times of economic depression.
How do You Speculate Currency?
In the traditional currency market, traders can enter in foreign exchange transactions with corporations or individuals who prefer currency conversion for commercial purposes as long as they perceive potential profits from those transactions.
For example, when a Swiss company is finding some purchasers for the conversion of the US dollar (USD) to Swiss franc (CHF), you can act as a trader who conducts a direct swap and charges a transaction fee for that. Should the market signal the probable increase in the Swiss franc’s value, you may speculate on price movements to reap gains by buying the currency. In case the market moves against your favor, you can trade Swiss francs with those who are looking for this currency.
Speculation in the Forex market
Heavy currency flows are recorded in the retail forex market as well. When participating in this decentralized and OTC market, traders implicitly do CFD trading with forex brokers. Without the ownership of physical currencies, traders do not actually deliver or receive such financial assets on the predetermined date. They purely engage in transactions to speculate on currency pairs and profit from changes in their values.
For example, when you open a long position of the EUR/USD, you anticipate the exchange rate of this pair will appreciate – that is, the value of the euro will increase against the US dollar. Conversely, when you go short on this pair, you count on the decrease in its price with hopes of the US dollar valued over the quote currency in the future.
Generally speaking, when traders stay on the forex market, they always function as speculators. However, the nature of forex itself is deregulated, which facilitates the participation of speculative traders, but can place them and even the global economy at stake provided that they have no proper trading strategies and no effective techniques to manage risks.
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