Understanding the Risks of Currency Speculation
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..
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
Posted in ...Investing