Curious about devaluation?
Did you know Forex traders bet on the differences between the perceived value of a currency and the actual value of the currency? Andy Krieger, Stanley Druckenmiller, and George Soros made hundreds of millions of dollars from these differences.
If you want to learn more about devaluation and how it makes traders money, read on.
What is Currency Devaluation
In modern times, a monetary devaluation is an intentional lowering of the value of a country’s currency performed by the country’s officials. It occurs only within fixed exchange rate systems. Monetary authorities formally set new fixed rates. These are for foreign reference currency or currency baskets.
For example, in 2008, Zimbabwe was printing one-hundred-trillion dollar bills. At the time, each was worth about 300 U.S. dollars at the time. The Zimbabwe government devalued the currency. One-hundred trillion ZWR was suddenly worth only one-hundred ZWL.
Notice they changed the currency code from ZWR to ZWL to reduce any confusion with the new bills.
The Cause of Devaluation
To understand why a country would devalue their currency, you must first understand inflation. Take a moment and think back to when you were a child. Do you remember the price of a candy bar? What about the price of gas? Of a McDonald’s cheeseburger?
Fast-forward to today. The difference in the price of your childhood cheeseburger and a cheeseburger today are due to inflation. It’s a natural byproduct of a healthy economy.
Inflation is the sustained increase in the price of goods or services in an economy over time. When price levels rise, the same unit of currency buys fewer goods or services. This reflects a reduction in purchasing power of that unit of currency.
Inflation and hyperinflation are caused by excessive growth of a country’s printed money supply. Rapid inflation is the sign of an unstable economy. Devaluation is the only way to counteract it.
How Devaluation Affects Forex
The value of any unit of currency fluctuates over time. The change is due to a variety of factors. These are a few:
- Interest rate differentials
- Economic fundamentals
- Political instability
- Risk Aversion
These fluctuations are the cornerstone on which currency foreign exchange (Forex) is founded. Essentially, traders purchase currencies they think will go up in value and sell those they think will go down.
Rapid fluctuations occur when a country devalues its currency. The fluctuations continue well after the country formally makes the adjustment. This increase and decrease in value are what traders bet on.
Here’s a fictional example: North and South Korea fix their political differences and decide to reunite. They both presently use the Korean won as their printed currency.
Their new government decides to devalue the South Korean won to help offset the difference between the two currencies. Then, they get rid of the North Korean won altogether.
If a Forex trader saw the currency change coming, they’d use puts, options, calls, and forwards to leverage their position. You can think of it like taking out a loan from the foreign government. After the devaluation happens, that same trader can then pay back the loan with the newly modified currency.
The net result is the trader pays back the loan at a discounted price. It’s one of the ways to make money on Forex.
Don’t let devaluation scare you. As a Forex trader, you can make a profit off of any fluctuations in the value of a currency. The trick is read the signs, so you know when to take advantage of these changes.
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