The Roles of Speculators and Central Banks in Foreign Exchange Markets - dummies

The Roles of Speculators and Central Banks in Foreign Exchange Markets

By Ayse Evrensel

Speculators and central banks are important participants in foreign exchange markets. Speculators invest in assets denominated in different currencies and, therefore, buy or sell currencies. Central banks may be engaged in foreign exchange markets to increase or decrease the value of their currency with respect to other currencies.

Speculators in foreign exchange markets

The generic term speculator includes a wide variety of market participants. Foreign exchange traders and brokers make up a relatively small segment among speculators; commercial banks, hedge funds, and other financial companies represent the most important group among speculators.

Regardless of type, speculators in foreign exchange markets want to profit from buying currency low and selling it high. In other words, all speculators try to make a profit from fluctuations in exchange rates.

The interbank market, which consists of large commercial banks and financial firms, is a major player in foreign exchange markets. Its activity helps determine the bid (buy) and ask (sell) price of currencies. This market has no trading floor, but banks can trade with each other directly or via electronic brokerage systems that connect market participants.

Multinational companies also engage in speculation because they make or receive payments denominated in various currencies to and from firms around the world. These currencies fluctuate on a daily basis. Therefore, multinational companies are also involved in speculation to hedge against their exchange rate risk.

Central banks in foreign exchange markets

Central banks have a unique place in foreign exchange markets. First, unlike the other groups involved in foreign exchange markets, the central banks’ involvement in foreign exchange markets doesn’t have a profit motive.

Second, central banks’ decisions regarding monetary policy are extremely influential on exchange rate determination. Central banks indirectly affect exchange rates through their monetary policy decisions. In every country, central banks are responsible for conducting monetary policy, among their other roles. The main goals of monetary policy are to promote price stability and economic growth.

Basically, a central bank addresses the domestic economy’s problems by changing the quantity of money and interest rates, which leads to changes in the exchange rate as well.

Third, central banks can directly affect exchange rates through interventions into foreign exchange markets. A central bank can use its domestic currency and foreign currency reserves to buy or sell foreign currencies directly in the foreign exchange market.

Alternatively, central banks may be involved in foreign exchange markets for reasons that aren’t related to their own countries but are related to the common concerns at the international level. For example, several central banks may come together in a joint action in foreign exchange markets to provide liquidity and credit across the world.