Apart from the long term capital flows in the form of direct and portfolio investments abroad, there is a flow of capital among nations for a short period (normally less than one year) as well.
These flows take the forms of export credit and loans, import debts, bank deposits, and commercial papers held abroad, foreign currency holdings and obligations etc.
Incidentally, it may be noted that the difference between long and short term capital flows is on the basis of instruments rather than the intentions of the investor. We have many more Short term Investing Help Articles Now Available.
The short term capital flows across nations take place due to a variety of factors. Further the determinants of these flows depend on the type of the flow. In order to explain their determinants, it is convenient to divide the short term flows into three categories viz., trade capital, arbitrage and speculative. The motives behind each of these flows and their determinants can be explained by the following viz: trade flows, arbitrage and speculative flows.
Exports and imports are negotiated both on down ayments as well as on redits. When down payments are made, bank deposits in exporting country’s currency increase while those in importing country’s decrease. In the case of transactions on credits, accounts receivables/payables increase. Since these accounts are usually payable within one year, they are included in short term capital flows. The volume of trade capital obviously varies directly with the magnitude of merchandise trade, and the credit relationships between trading partners
Arbitrage: Under arbitrage, individuals and institutions buy one currency and sell the other currency with the sole objective of making profits without taking any risk. The opportunity for such profits arises due to two factors. One, spot exchange rates are not quite consistent in all the worldwide markets. Two, the difference between spot (exchange) rates and forward rates is not always consistent with the interest rate differentials in different markets.
Speculative flows: Speculative flows of capital take place across countries with the sole objective of making money through deliberate understanding of foreign exchange risk. When the exchange rates fluctuate widely, it gives rise to significant speculative flows of capital. Speculators buy currencies which they expect to appreciate and sell those which they expect to depreciate. These transactions are subject to government regulations.
The magnitude of speculative flows depends directly on the variability of exchange rates, and the ability and attitudes of speculators towards risks. When the exchange rates were relatively stable, speculative flows were very much limited. With the increased variability of exchange rates and the enormous profits that the speculators in foreign exchange have made, the scope for such transactions has increased manifold and the trend is expected to continue in future. These speculations are perhaps the most difficult one. We have many more Investing Help Articles Now Available.