The Nuts & Bolts of Currency Speculation

Each time our currency appreciates/depreciates or markets face a liquidity problem, our respected finance minister makes a TV appearance and promptly blames it to currency speculation. An analogy to this syndrome can be found in home minister blaming every militant attack on “Foreign Hand”. Intrigued, I decided to engage my mental faculties to understand this phenomenon a bit more.

To understand the role of speculators, we must follow the mechanics of going short the domestic currency. Going short means that individuals sell a currency which they do not own. This is done in hope that they can buy it back at a later time at a cheaper price. In foreign exchange, the short sale is accomplished by selling the currency in a forward transaction. A forward foreign exchange transaction, has its value date further out on the settlement calendar than spot, the latter being a trade for nearly immediate settlement.

The forward sale of a currency involves paying a “lending fee” that is based on the spread between the interest rate of the currency being sold and the currency being bought. But this lending rate, rather than being explicitly stated is folded into the forward exchange rate. The amount by which the forward exchange rate diverges from the spot exchange rates, called the forward points, determines the cost of going short the currency. Herein lies the basic principle of currency trading: The higher the domestic interest rates, more expensive it is to maintain a short position in that currency.

This is why central banks may choose to hike its short-term interest rate to defend its currency in the face of market pressure. The idea is to try to muscle speculators out of the market by raising the cost of their going short but in doing so the bank must accept that it is damaging its own economy. Higher interest rates may lead to bankruptcies and higher rates of unemployment. That damage can be catastrophic, as has been evident in the history of emerging market nations where bank loans are typically based on floating interest rates. Needless to say, you would be seeing the finance minister a lot more on TV.

Demonisation of Foreign Exchange Markets

With the Rupee fluctuating from mid 30s to early 50s against the US dollar in period of just 1 year, the foreign exchange market, more than any other market has been cast in a villain’s role. Even heads of states have been known to visit invective upon the market. This kind of animosity may come from the fact that few heads of state study economics. Pursing no education seems to be a better preparation for a career in politics. Even very few chief executives have attained a fundamental understanding of the functioning of prices in modern economics. Prices, including exchange rates, are the agents that distribute scarce resources among competing demands. Prices do their work, without any one being conscious of their activity, much like the human body’s central autonomous system that controls its functioning.

Finance ministers and central bankers are supposed to know more about economics than heads of state do. Yet they too have an adversarial relationship with foreign exchange market because exchange rates have a habit of making them look silly; the currency market has made a monkey out of many a finance minister. In popular thinking, the whole foreign exchange market derives its existence from business centred on speculation. What is missed out in this rush to diagnose the foreign exchange markets is an important, if not crucial distinction about volatility.

In normal functioning markets, prices move up and down in more or less continuous manner. While a normal market can be trending up or down, it can even experience large fluctuations from time to time and there will be specialised agents willing to deal in derivatives contract. The importance of this is that derivatives are the principal tool that investors use to hedge foreign exchange risks. Among these are forward foreign exchange contracts and options on foreign exchange. Hence one can make an important generalisation that investors are not put off by the possibility that national currency will weaken over time – if that is their view, they can hedge, so long as there are dealers offering such instruments at a reasonable prices .Where this breaks down is in case of exchange rate that is capable of sharp discontinuous movements as has been witnessed in India recently owing to partially fixed exchange rate regime when Rupee started appreciating. Thus dollar rate crash seems inevitable in near future

In Defence of Free Capital Markets

If one copies from one source, it’s known as plagiarism and copying from multiple sources is known as research. To that extent, you would find this post, my first on this blog, a very well researched one. In fact, I have spent the last few months hopping from one economic blog to another in a vain attempt to understand the economic turmoil that we all are faced with. The financially turbulent era of “Sub prime crisis” is a challenge for market oriented economist to explain. The crisis has plagued countries around the world, leaving skeptical observers confounded by economic reversals and seasoned professional investors flat footed.

The age old debate of Free Capital Markets vs. Regulated Markets has been clinched; it seems for the time being, in favour of the latter. A broad spectrum of reforms has been recommended in the International financial system, following the remarkable collapse of Lehman Brothers and other financial giants. And when confronted with financial crisis, many leaders, if not all, hunt for villains and indict the Capital Markets instead of re-examining the policy blunders of their own making. The first blame goes to capital markets and the system that affords mobility to these markets. The witch hunting season has hit full bloom while and perpetrators of greed and mayhem roam scot-free under the cover of financial bailouts.

There exists remarkable evidence in history of all financial crises, that it is the government policies that has almost always, exacerbated the upheavals. In other words, the predisposing conditions of a crisis are local in nature; crisis comes from within and not outside, and certainly not because capital moves freely from one market to another or market determined forces. One lesson rings loud and clear, regulation or no-regulation, the world will see many more such financial crises unless governments refuse to indulge themselves in markets.