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.

How it works

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 using a fixed exchange rate are more susceptible to a speculative attack than countries using a floating exchange rate 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, it risks the chance of severe economic depression or financial collapse, as illustrated by the Argentine and 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 by foreign demand for local currency to pay for the country's exports has becoming 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 so by using its foreign exchange reserves, its holdings of foreign currency, to buy the local currency. However, it will be able to do so only 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, they may massively sell the local currency in exchange for foreign currencies, anticipating that when the central bank runs out of reserves and is forced to stop defending the local currency's price, the price of the local currency will drop sharply. If speculators calculate correctly, that may happen, and a currency crisis may occur, and they may make a capital gain on their foreign currency holdings rising in value, relative to the local currency.

Risks for speculators

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 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 price change, by taking opposing positions and reversing the engineered move.

Doing so may be assisted by aggressive intervention by a central bank directly, by very large currency transactions or raising interest rates, or indirctly, by another central bank with an interest in preserving the current exchange rate. As in cornering the market, attackers are left vulnerable.

See also

• Black Wednesday, in which a speculative attack on the pound sterling resulted in a forced withdrawal from the Exchange Rate Mechanism, a system of fixed exchange rates in the EU.
• Currency transaction tax
• Currency crisis
• Financial transaction tax
• Spahn tax
• Speculation
• Tobin tax

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