SPECULATION, RISK, CARRY TRADE AND FOREX SIGNALS

Speculation

Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Nevertheless, economists, including Milton Friedman, have argued that speculators ultimately are a stabilising influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it to those who do. Other economists such as Joseph Stiglitz consider this argument to be based more on politics and a free market philosophy than on economics.

Large hedge funds and other well capitalised ‘position traders’ are the main professional speculators. According to some economists, individual traders could act as ‘noise traders’ and have a more destabilising role than larger and better informed actors. Also to be considered is the rise in foreign exchange auto trading; algorithmic, or automated, trading has increased from 2 per cent in 2004 up to 45 percent in 2010.

Currency speculation is considered a highly suspect activity in many countries. While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not, according to this view. It is simply gambling that often interferes with any economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500 per cent per annum, and later to devalue the krona. Mahathir Mohamad, one of the former prime ministers of Malaysia, is one well-known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.

Gregory Millman reports on an opposing view, comparing speculators to ‘vigilantes’ who simply help ‘enforce’ international agreements and anticipate the effects of basic economic ‘laws’ in order to profit. In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their national economies, and foreign exchange speculators make the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling, eventually followed by a larger collapse. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from them for having caused unsustainable economic conditions.

Risk Aversion

Risk aversion is a kind of trading behaviour exhibited by the foreign exchange market when a potentially adverse event happens which may affect market conditions. This behaviour is caused when risk-averse traders liquidate their positions in risky assets and shift the funds to less risky assets due to uncertainty. In the context of the foreign exchange market, traders liquidate their positions in various currencies to take up positions in safe haven currencies, such as the US dollar. Sometimes, the choice of a safe haven currency is more of a choice based on prevailing sentiments rather than one of economic statistics. An example would be the financial crisis of 2008. The value of equities across the world fell while the US dollar strengthened. This happened despite the strong focus of the crisis in the US.

Carry Trade

Currency carry trade refers to the act of borrowing one currency that has a low interest rate in order to purchase another with a higher interest rate. A large difference in rates can be highly profitable for the trader, especially if high leverage is used. However, with all levered investments this is a double-edged sword, and large exchange rate fluctuations can suddenly swing trades into huge losses.

Forex Signals

Forex trade alerts, often referred to as ‘forex signals’, are trade strategies provided by either experienced traders or market analysts. These signals, which are often charged a premium fee for, can then be copied or replicated by a trader to his own live account. Forex signal products are packaged as either alerts delivered to a user’s inbox or SMS, or can be installed to a trader’s trading platforms.

Algorithmic trading, whereby foreign exchange users can program (or buy readymade software) to place trades on their behalf, according to pre-determined rules has become very popular in recent years. This means that users can set their ‘algos’ to trade on their behalf, thus reducing the need to sit and monitor the markets continuously. Plus, it can remove the element of human emotion around executing a trade.

With these basics of currency markets already studied, we shall now start exploring the dynamics of specific currencies, starting from the most circulated currency Dollar Index in the next article.

Disclaimer: The above opinion is that of the author and for reference only.