Speculation:

 Refers to the act of conducting a financial transaction that has substantial risk of losing
value, without firm evidence.
 Banks (brokers) attempting to capitalizing on their forecasts of anticipated exchange
rate movement in the foreign exchange market.
Example:
The Eupean Bank expects the exchange rate of the New Zealand dollar NZ($) to appreciate from
its present level of 0.50 euros to 0.52 euros in 30 days. The strategy is clear: Buy into the New
Zealand dollar and gain from the expected increase in value.
Given information: The European Bank can borrow 20 million on a short-term basis from other
banks.
Present short-term interest rates in the interbank market are as follows:

Currency Annualized Lending rate Annualized Borrowing rate

Euro 6.72% 7.20%
New Zealand dollar (NZ $) 6.48% 6.96%
*Annualized means annual rates.

Question 1:
If the European bank expects that the New Zealand dollar will appreciate from present level of
0.50 euros to 0.52 euros in 30 days. How can the bank attempt to profit (gain) from the
speculations?
Answer: for the sake of this example lets assume that the year has 360 day (not 365).
Steps:
1- Since the European bank can borrow 20 million euros, the first thing to do is borrow 20
million euros. (The annual borrowing rate is 7.20% check table)
2- Convert the 20 million euros to NZ$ (at the current rate which is 1 NZ$: 0.50 euros).
1 NZ $: 0.50 euros (using cross multiplication): (20,000,000*1)/0.50= 40,000,000 NZ$
20,000,000
3- The European bank then lends the New Zealand dollars (40,000,000) at the lending rate
of 6.48 % (look at table above). The rates given are annual rates and since the
expectation is for the value to appreciate within the next 30 days, we should calculate
and use the 30-day rate. 6.48% *30/360= 0.54 %.
0.54%= 0.0054. The mathematical trick to add the amount in one step is to use
1+0.0054= 1.0054.
 The bank will receive in 30 days after they get back the money, they lent out=
40,000,000*1.0054= NZ$ 40,216,000.
If this step is hard then just get the amount and add it to the 40,000,000 NZ$, step1
40,000,000*0.0054= 216,000, step 2 Add 216,000 to 40,000,000= NZ$ 40,216,000.
4- The European Bank then uses the proceeds from the New Zealand dollar loan (on day
30) to repay the initial euro loan that it took out with annual borrowing rate of 7.2%.
The 30-day rate is calculated as follows: 7.20% *30/360= 0.6%. 0.6%= 0.6/100= 0.006.
therefore, 20,000,000 euros*1.006= 20,120,000 euros.
Using the new rate according to speculation the 20,120,000 when converted to New
Zealand dollar 20,120,000/0.52= makes 38,692,308 NZ$.
5- Given that the European bank accumulated NZ$ 40,216,000 from its New Zealand dollar
loan, the bank would earn Speculative Profit of 40,216,000-38,692,308= NZ$1,523,692.
6- Since the European Banks currency is euro we convert the profits back to euro using the
new rate 1,523,692*0.50= 792,320 euros of Speculative Profits.
Question 2:
If instead the European bank expects the New Zealand dollar to depreciate, how can it attempt
to capialtize (profit) ?
Answer: