A speculator not only accepts exchange rate risk but also seeks if. To him, an “open position” is an opportunity to make a profit.
His success or failure depends upon how correctly he is able to anticipate the exchange rate variations. [It should be noted that the actions of the speculators also contribute to the market outcome, and it can be a dominating contribution].
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These days, a lot of transactions take place due to speculation and with a motive for profit. These transfers have been made possible by not only expanded trade volume, but also by portfolio investments (and a lot of floating funds).
These transactions have been facilitated by easier convertibility of currencies and quicker, cheaper and easier means of Communications and funds transfers.
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Current account convertibility is found in a very large number of countries, followed by those which have also partial (or full) capital account convertibility.
If someone buys a foreign currency in the spot, or forward market, or buys an option to buy a foreign currency, and expects to sell it later at a higher spot rate, he is said to have taken a long position in the currency, or taking a net asset position.
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In contrast, if someone sells a foreign currency in the spot or forward market and expects to buy it later at a lower price, he is said to have taken a short position, or a net liability position.
Speculation in foreign exchange market can be either stabilising or destabilising. It has a stabilising effect on rate of exchange, if it works in favour of restoring stability to the exchange rate.
In contrast, it has a destabilising’ effect if it contributes to instability of the exchange rate. Let us clarify this further by considering two cases of the dollar-rupee exchange rates.
Case 1:
(a) Let the market believe that the price of dollar in rupees is “low”; or if it has fallen, let the market expect it to rise back to its “normal” level.
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Then, in this case, buying of dollars by speculators will result in restoring the rate to its normal level, and this activity of speculators will be termed a stabilising one.
(b) Let the market believe that price of dollar in rupees is “high”, or if it has risen, let the market expect it to fall back to its “normal” level.
Then, in this case, selling of dollars will have the effect of restoring the rate to its normal level, and this activity of speculators will be termed a stabilising one.
Case 2:
(a) Let the market believe that the price of dollar in rupees is “low”; or if it has fallen, let the market expect it to fall further away from its “normal” level.
Then in this case, the selling of dollars by speculators will have the effect of pushing the rate further down, way lower than its normal level. This activity of speculators will be termed a destabilising one.
(b) Let the market believe that price of dollar in rupees is “high”; or if it has risen, let the market expect it to rise further away from its “normal” level.
Then, in this case, buying of dollars by speculators will have the effect of pushing up the rate even higher from its normal level. This activity of speculators will also be termed a destabilising one.