Definition: “Speculation” in Foreign Exchange is an act of buying and selling the foreign currency under the conditions of uncertainty with a view to earning huge gains.
Often, the speculators buy the currency when it is weak and sells when it is strong. Also, if the spot rate of the currency is expected to increase in the future, then the speculator buys forward and sell “on the spot” the currency bought by him. On the contrary, if the speculator anticipates a fall in the exchange rate, then he “sells forward” at the current rate and buy the spot when the currency is needed for the delivery.
The speculation is said to have both the stabilizing and destabilizing impact on the exchange rate. Such as, if the speculator buys the currency when it is cheap and sells when it is dear, is said to have a stabilizing effect on the exchange rate. However, there is a controversy with respect to the stabilizing and destabilizing of exchange rate due to the speculative transactions.
One of the controversial conditions for destabilizing speculation is that “selling a currency when it is weak, expecting it to get weaker or buying it when the price rise in the expectation that it will rise more.” However, Milton Friedman has pointed out that the speculation is said to be stabilizing, if the exchange rate were highly overvalued or undervalued and speculation drove it towards equilibrium thereby reinforcing the market movements.
According to Robert Aliber, “ The speculation is said to be destabilizing if the spot and forward markets move in the same direction rather than in opposite directions”. In a general view, if the speculation pushes the exchange rate beyond or below the critical level form where the return is impossible or disadvantageous, it is said to be destabilizing.
However, the advocates of flexible exchange rate believe that the speculation cannot be destabilizing. Thus, it can be concluded from the above discussion, that when the speculator buys the currency when it is weak and sells when it is strong, then it will be stabilizing.