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Speculative attack

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Title: Speculative attack  
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Subject: Self-fulfilling crisis, Fixed exchange-rate system, Speculative, Beyond the Crash, Onion Futures Act
Collection: Financial Crises, Financial Markets
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Speculative attack

In economics, a speculative attack is a precipitous acquisition of some assets (currencies, gold, emission permits, remaining quotas) by previously inactive speculators. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board. Paul Krugman, who visited the Board as a graduate student intern, soon [1] adapted their mechanism[2] to explain speculative attacks in the foreign exchange market.[3]

There are now many hundreds of journal articles on financial speculative attacks, which are typically grouped into three categories: first, second, and third generation models. Salant has continued to explore real speculative attacks in a series of six articles.

Dynamics

A speculative attack in the foreign exchange market is the massive selling of a country's currency assets by both domestic and foreign investors. Countries that utilize a fixed exchange rate are more susceptible to a speculative attack than countries utilizing a floating exchange rate. This is because of the large amount of reserves necessary to hold the fixed exchange rate in place at that fixed level. Nevertheless, if a government chooses to maintain a fixed exchange rate during a speculative attack, they risk the chance of severe economic depression or financial collapse, as illustrated by the Argentine and East Asian financial crises.

Under a fixed exchange rate, the country's central bank is committed to maintaining a given price of the home currency in terms of foreign currencies, by participating when necessary in the foreign exchange market as a buyer or seller of the country's currency, to ensure that supply and demand are equated at the chosen price. When demand for the home currency becomes weaker than supply, perhaps because foreign demand for local currency to pay for the country's exports has become weak, maintaining equality of supply and demand for the currency at the chosen price involves the central bank stepping in as an additional demander of the local currency; the central bank does this by using its foreign exchange reserves—holdings of foreign currency—to buy the local currency. However, it will be able to do this only unless and until it runs out of foreign exchange reserves. If speculators predict that the central bank will not be able to defend the currency in the face of a speculative attack, because it will run out of reserves, the speculators may massively sell the local currency in exchange for foreign currencies, anticipating that when the central bank runs out of reserves and is thus forced to stop defending the local currency's price, the price of the local currency will drop sharply. And in fact if they have calculated correctly, exactly that may happen, a currency crisis may occur, and the speculators may make a capital gain on their foreign currency holdings as they rise in value relative to the local currency.

A speculative attack has much in common with cornering the market, as it involves building up a large directional position in the hope of exiting at a better price. As such, it runs the same risk: a speculative attack relies entirely on the market reacting to the attack by continuing the move that has been engineered, in order for profits to be made by the attackers. In a market that is not susceptible, the reaction of the market may, instead, be to take advantage of the change in price by taking opposing positions and reversing the engineered move.

This may be assisted by aggressive intervention by a central bank, either directly through very large currency transactions or through raising interest rates, or by activity by another central bank with an interest in preserving the current exchange rate. As in cornering the market, this leaves the attackers vulnerable.

See also

References

  1. ^ Krugman
  2. ^ Stephen Salant and Dale Henderson (1978), "Market anticipations of government policies and the price of gold." Journal of Political Economy 86, pp.627-48
  3. ^ Paul Krugman (1979), 'A model of balance-of-payments crises'. Journal of Money, Credit, and Banking 11, pp. 311-25.
  • Bank of Portugal report on the defense of the Portuguese Escudo in the European exchange rate mechanism
  • Federal reserve bank of San Francisco article on the failed attack on the Hong Kong dollar
  • IMF report on emerging market currency crises
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