Economic crisis and failure of economic policies in the financial market can be attributed to excess currency speculation. Currency speculation involves buying of foreign currencies when the prices are low hoping they will appreciate and anticipating to sell them when their prices increase. It is a high risk investment that promises high returns to the speculator. However, with poor speculation, the investor is likely to realize massive losses (Dibooglu, 1998).
The forward exchange rate speculation can be done by analyzing the relative inflation rates and relative interest rates between two economies. It involves the use of the purchasing power parity theorem to determine the future spot rate with regards to the relative inflation rates. At the same time, the interest rate parity “principle can also be used to predict” the forward currency exchange rate (Chance & Brooks, 2012). When speculating the movement in the currency exchange rates, an investor analyzes various factors that influence the two currencies such as political situation, economic development, weather conditions, current account positions between the two countries, levels of the counties’ public debt, foreign currency supply and demand in the forex market (Bergen, 2014). For instance, assuming the inflation adjusted interest rate in the United states to be 7.1 percent and that in Germany to be 2 percent, and the spot rate given as EUR/USD = 1.3435, the forward exchange rate can be determined as follows
Forward rate = Spot rate x (1 + If) where If – interest rate of foreign country
(1 + Ih) and Ih – interest rate of home country
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The forward exchange rate would be calculated as 1.3435 x 1.071/1.02 = 1.41.
In this instance, the conviction is that the economic situation in United States will worsen, supply for Euros will reduce as the demand for the same increases making the US Dollar to depreciate. The price of the Euro will increase due to the market deficiency resulting in an increase in the exchange rate as calculated above (Bergen, 2014).
The speculation process may result into a profit or loss for the investor. For instance, at the spot rate, the amount received would be €372,162.2627 ($500,000 x 1/1.3435). The twelve month forward will yield US $510,048.381 (€372,162.2627 x 1.3705) according to the market predicted forward rate. There will be an alteration in the sum of investment from US $500,000 to US $510,048.381. This represents a profit of US $10,048.381, a 2.01 percent return on investment. However, using the investor’s speculated 12 months forward currency exchange rate, amount received at the end of the twelve months would be US $524,748.7904 (€372,162.2627 x 1.41). The resultant effect will be a profit of US $24,748.7904. This represents a 4.95 percent return on investment (Neftci, 2000).
The 12 month forward rate used has been adjusted against interest rate and inflation changes. From the above results, if the investor can speculate the market correctly, the returns would be higher. Nevertheless, the risk associated with such speculation is very high and the impact is equally significant. For instance, if the forward rate remains at 1.3705 as predicted by the market, the investor would lose US $14,700.4094, a 59.4 percent decline from the speculated profits.
The forward exchange market is very uncertain and the process of determination of the forward rate is very subjective and has several limitation. For example, the purchasing interest rate parity theorem ignores the effects of capital flows on the currency exchange rates. The inflation rates used may also be nothing but mere estimates which are objectively defined. The exchange rate only considers the prices of commodities in international trade but not the general price level as the latter incorporates non-tradable commodities. Government controls may contain exchange rates hence affecting the operations of forward markets (Sercu, 2009).
Therefore, other derivatives such as currency options and futures contracts can be used to minimize the risks in international trade. When trading in currency options, the investor can determine the price of the options being traded with a high level of certainty. The options also have an exercise price and “the investor will not exercise the option if” doing so will result into losses. In addition, options also have the capability of delivering high returns. They are cost efficient as they have a high leverage power. Options are very flexible and offer more investment alternatives to the investor. The best derivatives to use are the synthetic options. This is a combination of an option and a short stock or long stock. They are very flexible, dynamic and offer higher returns. “The use of the Black and Scholes Option Pricing Model” makes it easier to determine the value of an option enabling the investor to decide whether exercising the option will place him/her in the money, at the money or out of the money positions.
In conclusion, currency speculators can record massive earnings as shown above and at the same time make enormous losses due to some unpredictable occurrences that drive down some economies. This currency speculations has a currency depreciation signal that has grave impact on the economy. They make the financial markets vulnerable and prone to crisis. Investors should evaluate the risk of each investment, analyzing the returns and the risks involved in each then selecting those investments that promise high returns at lower risks. These include trading in options and futures contract. In the above case, the investor can consider the options market and/or futures market for diversification of risk.
- Bergen, J. V. (2014, September 20). Factors Influencing Exchange Rates. Retrieved from Investopedia: http://www.investopedia.com/articles/basics/04/050704.asp
- Chance, D., & Brooks, R. (2012). Introduction to Derivetaives and Risk Management, 9th Edition. Ohio: South-Western Cengage Learning.
- Dibooglu, S. (1998). Forward Speculation, Excess Returns, and Exchange Rate Variability: The Role of Risk Premiums. Review of International Economic, pp. 427-440.
- Neftci, S. N. (2000). An Introduction to the mathematics of Financial Derivatives, 2nd Edition. Massachusetts: Academic Press.
- Sercu, P. (2009). International Finance; Theory and Practice. New Jersey: Princeton University Press.
