Understanding the Risks of Currency Speculation

Currency speculation involves buying, selling and holding currencies in order to make a profit from favorable fluctuations in exchange rates. Small investors can often be overwhelmed by the amount of information and the complexity of variables at play, which is why it is important to understand the factors that influence profitability. Professional traders often have a bevy of resources available, but this doesn’t mean that forex is so complicated as to be left to the pros. It is estimated that 95% of forex participants are currency speculators, with players that include large multinationals, investment banks, hedge funds and professional traders.

An exchange rate is the rate at which one currency can be exchanged for another, and is always quoted in pairs (“currency pair”), such as EUR/USD (Euro and US..
Dollar). Fluctuations in exchange rates occur as a result of changes in economic factors, such as inflation and industrial production, as well as due to significant geopolitical events, such as revolutions or changes in leadership. These factors influence a trader’s decision to buy or sell a currency pair.

Currency speculation involves a high degree of risk, since predicting what events will influence exchange rates during a specific period of time, as well as the magnitude of the influence, is very difficult. For instance, if a trader believes that the Euro will strengthen (“appreciate”) against the U.S. dollar, then the trader will buy Euros with U.S. dollars. If the exchange rate rises and the investor thinks that the appreciation will taper off, the investor can buy U.S. dollars with the Euros that were purchased. The profit is made by the use of arbitrage: the difference between the currency exchange rates. In the previous example, if the trader buys Euros with U.S. dollars and the Euro does not appreciate, the trader could lose money because the Euros are not worth as much as before.

Currency speculation can have serious consequences on a national currency and accordingly on a country's economy. While a major benefit of speculation is an increase in liquidity (more units of currency are used in transactions rather than reserves), speculation can also devalue or inflate a currency to the point at which a country’s stock market and overall economy starts to follow suit. Heavy trading in a currency creates “artificial demand”, and can increase the prices of goods beyond an inflation-adjusted level. Some major crises occurred when Brazil devalued its currency in 1999. For country’s with fixed exchange rates, currency speculation can lead to a major crisis, as was seen in several Asian countries in 1997, and in both Brazil and Argentina in 1999.
By InvestorGuide Staff

Copyrighted 2016. Content published with author's permission.

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