An Introduction to Currency Trading - III

Speculation is the act of taking risk by buying or selling an asset to take advantage of future price change. It is one of the most important aspects of the Forex market. About 80-90% of currency transactions have nothing to do with the end-user demanding foreign exchange for trade or payment purposes. Speculation provides liquidity to the market and reveals the true value of currencies in terms of other currencies. It is triggered when economic and political indicators of a nation worsen or necessary reforms are not carried out.

Before delving more into currency speculation let us look at the two different types of exchange rate mechanisms: fixed and floating. In a fixed exchange rate system, the value of the country's currency vis-à-vis other currencies is fixed and can only change within a certain narrow margin. In a floating exchange rate system, the value of the country's currency vis-à-vis other currencies is allowed to change according to the supply and demand which is affected by the policies and macro-economic performance of the country.

Attacks on currencies occur when "fundamentals" of an economy go wrong. Increase in unemployment and poverty levels, price increases due to inflation and import curbs, increased violence and unrest, and failure of social security systems are some of the most important causes of currencies coming under attack.

In 1992, the EMS (European Monetary System) experienced a series of crises. Germany followed a tight monetary policy due to inflationary pressures caused by its unification. Short-term interest rates rose to 10% by 1992. This caused the other members to tighten their monetary policies though they were experiencing rising unemployment levels and low inflation rates to maintain their rates with the deutsche mark.

Speculators believed that this parity cannot continue and ultimately will collapse. In September 1992, UK, Finland and Italy pulled out of the ERM. More countries followed suit. Selling pressures on these currencies were stupendous and they fell through their ERM floors. The intervention of central banks could not stop the speculative binge. Finally the trading bands were widened which allowed the countries much greater latitude to change interest rates independently and the speculative crisis stopped.