Empirical evidence shows that the process of capital account liberalization has advanced considerably in the Czech Republic and the enforcement of some capital controls has been exercised with a high degree of benevolence. The present institutional environment thus offers rather favourable conditions for both inflows and outflows of foreign capital. As a result, this recent development raises issues concerning hot money and disruptive capital flows which one can observe extensively in developed market economies. The paper explores various forms of hot money flows and their potential impacts on the Czech exchange rate policy which can be described as a one which puts great emphasis to the exchange rate stability. First, exchange rate speculator is defined as a person who deliberately creates open positions in foreign currencies in order to earn quick and substantial profits from exchange rate fluctuations. It has been pointed out to a dangerous situation of so-called one-way expectations about the way the exchange rate has to move in order to restore external equilibrium. Among further forms of exchange rate speculation one can distinguish also lads and lags, under or overinvoicing, mismatching of assets and liabilities on part of commercial banks. In contrast to speculation the arbitrator strives to earn profits with minimum or no risk at all. His main role consists in exploiting and closing price anomalies between different market-places or within a time interval. The Czech Republic creates convenient conditions for uncovered interest rate arbitrage which aims to exploit interest rate differential. Especially the fixed exchange rate arrangement is conducive to these financial operations as it deprives speculators from exchange risks. Interest rate parity condition also makes it difficult to follow independent monetary policy. So called covered interest rate arbitrage uses forward markets and tries to reap profits from the differential between spot and forward exchange rates. The final part of the paper discusses the question about compatibility of three policy goals: independency of monetary policy, liberalization of capital flows and exchange rate stability. There are some risks for transition economies if they are lifting capital controls in the environment of a pegged exchange rate, as their fundamentals may not cope with those of reference countries.
