Foreign Exchange The Role of Speculation

We have seen that both commercial (export-import) and interest arbitrage transactions operate in the forward market and are part of the machinery of forward rate determination. What, now, about speculation? Speculation may have very large influence in the forward market.

The speculator, of course, unlike the interest arbitrager or the foreign trader, is not using the forward market to cover a spot transaction. Rather he takes an open or uncovered position in forward exchange. For example, if the American speculator thinks the future course of Euro exchange is going to be weak in comparison with spot rates, he sells Euro forward, hoping to be able to cover these sales 30, 60, or 90 days later at a still lower rate. If he thinks Euro is going to be strong he buys future Euro (or sells futures of a foreign currency against Euro), hoping to be able to dispose of them at a better rate later. During a heavy "bear" movement, speculation can drive down the forward rates on a given exchange to very large discounts.

Bear speculators, then, may drive forward rates to sizable discounts. It is then possible for interest arbitragers--especially bankers--to sell spot exchange and buy futures. These transactions will partially offset the speculation and sustain the forward rate, but they will at the same time put selling pressure on the spot exchange market. If a country is precariously perched on the gold standard a gold outflow will likely result.

So it is that the forward market in foreign exchange, just as the "futures" markets in staple commodities such as cotton and wheat, serves a dual purpose: a means whereby foreign traders can hedge against fluctuations in exchange rates, and a medium for speculation. In the absence of interest arbitrage and speculation it is doubtful if a continuous forward market would be possible, dependent as it would be on foreign trade for its supply of and demand for forward exchange; that is, "interest arbitrage and speculation mix in with supply and demand from the side of trade, bridging over differences as to the amounts and as to the period to be covered."