Under currency trading, the case of freely convertible currencies and the lack of exchange control, chance of speculative elements are usually high. Speculators tend to buy “strong currency” with the “weak currencies” – which they might be possessing or have borrowed.
They try to gamble on both possibilities of expecting revaluation or devaluation or sharp changes in exchange rates under floating of a currency. Under speculative motive, the buying of the currency, the exchange rate of which is supposed to rise, sharply increases; and the selling of the currency, the exchange rate of which is supposed to fall, also sharply increases. The former is regarded as a stronger currency and the later as weaker currency by speculators.
Speculation normally arises when the speculators judge that the parity between two currencies is inappropriate. They observe that the parity does not reflect the real purchasing power of a weaker currency in exchange rate against the stronger currency, when it is overvalued. This is normally gauge through the balance-of-payments position of the country in question. Speculation is not directed to changing the parity directly but the exchange rate.
To control and regulate short-term capital flows, the Central Bank of a country intervene directly on the foreign exchange market when the national currency is floating. The intervention is meant to influence the exchange rate. Intervention implies either buying or selling of foreign currency. When the Central Bank buys foreign currency through home currency in the forex market, the exchange rate is raised. When it sells the foreign currency, thus, buying domestic currency through foreign currency in the forex market of the country, the exchange rate is lowered.
The Central Bank intervention is. usually in the form of cash or forward deals of foreign exchange involving a time shift which is desirable for necessary adjustments in the country’s reserve position.
Another mode of Central Bank intervention is indirectly through use of credit/monetary policy. The Central Bank when requires inflow of foreign capital may raise or maintain a high interest rate. The interest rate differentials between countries induce international capital movement from low interest rate country to a higher interest rate* country under free conditions.
A higher interest rate country may attract portfolio investment as well as foreign direct investment, thus, inflow of capital. For foreign direct investment, however, economic fundamentals, potential growth rate of output and government’s positive attitude and policies are more significant. Apparently, arbitrage mechanism tends to establish uniform exchange rates in different markets.