Is It Possible to Open Short Positions and Speculate on Fall of Exchange Rate?

Answer 1

Essentially, yes. Some useful concepts for analyzing this situation include understanding long and short positions of assets, foreign exchange transactions, carry trades and uncovered interest rate parity, future and forward transactions and covered interest rate parity, and the no arbitrage principle applied to foreign exchange.

A long position represents an asset held. A short position represents an asset borrowed. Taking out a loan opens a long position in current currency and a short position in a future currency. For this question, we will assume all loans are risk-free so that we can focus entirely on speculating on the foreign exchange risk and potential reward.

A foreign exchange contract exchanges one currency for another. Accordingly, at a moment in time, buying one currency requires gives up another. The price of this transaction is known as the FX spot rate (e.g. GBP/USD). Using the present funds from our loan, we could buy a foreign currency today at the spot rate. Even better, we might buy risk-free bonds, essentially loaning money in the foreign currency and earning a return while borrowing in the domestic currency.

With "carry trades," investors borrow in one currency ideally at a low interest rate and invest in another currency ideally at a higher interest rate. If the exchange rate does not change or changes a sufficiently small amount, the investor will capture a profit. The rate of return is represented by the uncovered interest rate parity equation in which the investor bears risk and might earn profit and loss.

To accomplish a similar result, forwards and futures contracts can be used to agree to a transaction at a future date, so if prices rise or fall, the value of a foreign exchange future or forward contract will change. If the investor borrows in a domestic currency, converts the loan proceeds to a foreign currency, buys foreign bonds, and uses a futures contract converting the proceeds back to pay off the loan, the investor should have zero risk and should earn zero profit, following the covered interest rate parity approach.

More broadly, earning instantaneous risk-free profit should be impossible. This is the meaning of the "no-arbitrage principle." The covered interest rate parity equation follows the no-arbitrage principle; the uncovered interest rate parity approach of the carry trade does not and appears to represent the speculative approach you seek.

Ultimately, it seems, for example, that you would wish to borrow dollars, buy the corresponding amount of British pounds or British bonds payable on a future (forward) date, and hope that dollars get cheaper than pounds in the meantime. Then, you would have the funds to repay your dollar loan in full and pocket a profit!