Hedge fund managers reportedly made huge profits shorting the pound as it fell to near par with the US dollar following Chancellor Kwasi Kwarteng’s September “mini-budget”.
Sterling’s latest fall came on October 11 after Andrew Bailey, the governor of the Bank of England, announced he was ending an emergency support package for pension funds at risk of collapse following market turmoil following Mr Kwarteng’s statement to MPs. .
Here we explain what happens in the forex markets:
What is shorting?
Short selling is when investors speculate on the decline in the price of a stock or other security. They do this by borrowing stock in a company they believe will decline in value.
They then sell these borrowed shares to buyers at the current market price. They are betting that the price will then fall and they can buy back the borrowed stock at a discounted price before they have to pay it back. The profit they make is the difference between what they earned for selling the stock and the price they paid to buy it back.
Most short selling is done in stocks and shares, but you can also short sell other financial markets – such as currency trading markets.
What does shorting the pound mean?
Shorting the pound means taking a position that will make you a profit when the value of the pound falls.
Traders do this in the foreign exchange or Forex markets, where currencies are converted into other currencies.
Forex trades in pairs of different currencies. So, for example, you could trade a pair with the pound as the base currency (the first currency) and the US dollar as the bid currency (the second currency).
Traders making money would have sold pairs with the base currency GBP before the crash or early in the pound’s decline against the dollar.
It is also possible to short currency pairs using other financial instruments called derivatives. These effectively allow you to bet on the movement of the underlying asset without owning it.
This type of trading can make markets very volatile, especially when many people pile into the same trade.
What is Forex Speculation?
Speculation in the world of finance essentially refers to taking a risky bet. Speculators make financial transactions that have the risk of losing value, but also have the potential to gain significant value.
Investors look at how the price of the thing they have bought will change and try to make money from that change. Speculators do not seek to buy the product directly, but rather want to make money from fluctuations in the market.
So, for example, in currency speculation, the investor will be looking to buy a particular currency so that he can sell it at a higher price in the future. They are not looking to buy it so they can pay for an import.
What is parity?
There has been a lot of talk in recent days about the exchange rate between the British pound and the US dollar. Parity simply means that the dollar and the pound have the same value.
It currently costs around $1.10 to buy £1. But if the currencies reach parity, that means $1 will be worth £1.