Can currency speculation be a determinant of an exchange rate?
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Currency speculation could help to determine exchange rates. However, the speculation would have to be on a relatively large scale.
When an exchange rate is allowed to float that rate is determined by supply and demand. The more that people want a given currency, the more its value is likely to appreciate. The more people want to sell a given currency, the more likely it is to weaken. Therefore, if speculation were strong enough and in a consistent direction, it could impact an exchange rate. For example, if speculators were very sure a certain currency would get stronger, they might buy it in large quantities. The greater demand for the currency could cause its value to rise.
Currency speculation can and in many cases is the reason behind currencies of various nations getting devalued at an extremely fast rate and to levels not justified by economic fundamentals. Some famous examples of the same include a currency crisis in the UK when the pound was devalued to unreasonable levels due to massive short selling of the currency by funds owned by George Soros. In addition to the profits made by him this also led to him getting the title of "The Man Who Broke the Bank of England."
When the economic fundamentals of a nation like the balance of payment, inflation, prevailing interest rates, etc. are strained speculators in the forex market are the first to start selling or buying the currency in an effort to make a profit from the resulting change in the exchange rate. This change is often extreme and can cause a lot of damage to the economy of the nation. Often, the only way to restore balance is for central banks to intervene and curtail speculative activities. An example of this is the Indian rupee recently hitting an all time low against the US dollar which was difficult to justify solely on economic conditions prevailing in India, the fiscal deficit, and the alike. To correct the exchange rates and bring them to a reasonable level the Central Banking Authority of India had to step in and restrict speculation in the INR by making buying and selling of currency futures possible only for genuine hedging purposes.
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