“Speculation” in Foreign Exchange Market

 “Speculation” in Foreign Exchange  is an act of buying and selling the foreign currency under the conditions of uncertainty with a view to earning huge gains.

Often, the speculators buy the currency when it is weak and sells when it is strong. Also, if the spot rate of the currency is expected to increase in the future, then the speculator buys forward and sell “on the spot” the currency bought by him. On the contrary, if the speculator anticipates a fall in the exchange rate, then he “sells forward” at the current rate and buy the spot when the currency is needed for the delivery.

The speculation is said to have both the stabilizing and destabilizing impact on the exchange rate. Such as, if the speculator buys the currency when it is cheap and sells when it is dear, is said to have a stabilizing effect on the exchange rate. However, there is a controversy with respect to the stabilizing and destabilizing of exchange rate due to the speculative transactions.

One of the controversial conditions for destabilizing speculation is that “selling a currency  when it is weak, expecting it to get weaker or buying it when the price rise in the expectation that it will rise more.” However, Milton Friedman has pointed out that the speculation is said to be stabilizing, if the exchange rate were highly overvalued or undervalued and speculation drove it towards equilibrium thereby reinforcing the market movements.

According to Robert Aliber, “ The speculation is said to be destabilizing if the spot and forward markets move in the same direction rather than in opposite directions”. In a general view, if the speculation pushes the exchange rate beyond or below the critical level form where the return is impossible or disadvantageous, it is said to be destabilizing.

However, the advocates of flexible exchange rate believe that the speculation cannot be destabilizing. Thus, it can be concluded from the above discussion, that when the speculator buys the currency when it is weak and sells when it is strong, then it will be stabilizing.

“Arbitrage” in Foreign Exchange Market

 Arbitrage is the process of a simultaneous sale and purchase of currencies in two or more foreign exchange markets with an objective to make profits by capitalizing on the exchange-rate differentials in various markets.

The arbitrage opportunities exist due to the inefficiencies of the market. While dealing in the arbitrage trade, an individual can make profits only out of price differences of similar or identical financial instruments traded on different exchange markets. Thus, the price differential is captured as a trade’s net payoff. This payoff should be large enough to cover the expenses incurred in executing the trade.

For example: Suppose the stock of company A is trading at Rs 2000 on BSE while the same stock is trading on NSE at Rs 2500. A trader can earn a profit of Rs 500 by buying the stock on BSE and immediately selling the same shares on NSE. This arbitrage opportunity can be availed until BSE runs out of shares of company A or until BSE and NSE adjusts the price differences so as to wipe out the arbitraging opportunity.

The importance of arbitrage lies in its ability to correspond foreign exchange rates in all the major foreign exchange markets. The arbitraging involves the transfer of foreign exchange from the market with a lower exchange rate to the market with a higher exchange rate. Hence, arbitraging equates the demand for foreign exchange with its supply, thereby acting as a stabilizing factor in the exchange markets.

The arbitrage opportunity can be availed only where the foreign exchange is free from controls, and if any, controls should be of limited significance. If the sale and purchase of foreign exchange are under severe control and regulation, then the arbitrage is not possible. Practically, the arbitrage opportunity exists for a very brief period since in the mature markets the most of the trading has been taken by the algorithm-based trading (a trading system that relies heavily on mathematical formulas and computer programs to determine the trading strategies). These algorithm-based trading are quick to spot and is quite easy for a trader to keep track.

Types of Foreign Exchange Transactions

The Foreign Exchange Transactions refers to the sale and purchase of foreign currencies. Simply, the foreign exchange transaction is an agreement of exchange of currencies of one country for another at an agreed exchange rate on a definite date.

1. Spot Transaction: The spot transaction is when the buyer and seller of different currencies settle their payments within the two days of the deal. It is the fastest way to exchange the currencies. Here, the currencies are exchanged over a two-day period, which means no contract is signed between the countries. The exchange rate at which the currencies are exchanged is called the Spot Exchange Rate. This rate is often the prevailing exchange rate. The market in which the spot sale and purchase of currencies is facilitated is called as a Spot Market.
2. Forward Transaction: A forward transaction is a future transaction where the buyer and seller enter into an agreement of sale and purchase of currency after 90 days of the deal at a fixed exchange rate on a definite date in the future. The rate at which the currency is exchanged is called a Forward Exchange Rate. The market in which the deals for the sale and purchase of currency at some future date is made is called a Forward Market.
3. Future Transaction: The future transactions are also the forward transactions and deals with the contracts in the same manner as that of normal forward transactions. But however, the transactions made in a future contract differs from the transaction made in the forward contract on the following grounds:

• The forward contracts can be customized on the client’s request, while the future contracts are standardized such as the features, date, and the size of the contracts is standardized.
• The future contracts can only be traded on the organized exchanges, while the forward contracts can be traded anywhere depending on the client’s convenience.
• No margin is required in case of the forward contracts, while the margins are required of all the participants and an initial margin is kept as collateral so as to establish the future position.

4. Swap Transactions: The Swap Transactions involve a simultaneous borrowing and lending of two different currencies between two investors. Here one investor borrows the currency and lends another currency to the second investor. The obligation to repay the currencies is used as collateral, and the amount is repaid at a forward rate. The swap contracts allow the investors to utilize the funds in the currency held by him/her to pay off the obligations denominated in a different currency without suffering a foreign exchange risk.
5. Option Transactions: The foreign exchange option gives an investor the right, but not the obligation to exchange the currency in one denomination to another at an agreed exchange rate on a pre-defined date. An option to buy the currency is called as a Call Option, while the option to sell the currency is called as a Put Option.

Thus, the Foreign exchange transaction involves the conversion of a currency of one country into the currency of another country for the settlement of payments.