Speculative attack

Last updated

In economics, a speculative attack is a precipitous selling of untrustworthy assets by previously inactive speculators and the corresponding acquisition of some valuable assets (currencies, gold, emission permits, commodities, Bitcoin, remaining quotas). 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]

Contents

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 and sudden selling of a nation's currency, and can be carried out by both domestic and foreign investors. A speculative attack primarily targets currencies of nations that use a fixed exchange rate and have pegged their currency to a foreign currency, such as Hong Kong pegging the Hong Kong Dollar (HK$) to the United States Dollar (US$) at an exchange rate of HK$7.8 to US$1; generally the target currency is one whose fixed exchange rate may be at an unrealistic level that may not be sustainable for very much longer even in the absence of a speculative attack. In order to maintain a fixed exchange rate, the nation's central bank stands ready to buy back its own currency at the fixed exchange rate, paying with its holdings of foreign exchange reserves.

If foreign or domestic investors believe that the central bank does not hold enough foreign reserves to defend the fixed exchange rate, they will target this nation's currency for a speculative attack. The investors do this by selling that country's currency to the central bank at the fixed price in exchange for the central bank's reserve currency, in an attempt to deplete the central bank's foreign reserves. Once the central bank runs out of foreign reserves, it no longer is able to purchase its currency at the fixed exchange rate and is forced to allow the currency to float. This often leads to the sudden depreciation of the currency. As many large nations have massive amounts of foreign reserves, often referred to as war chests, speculative attacks often target smaller nations with smaller war chests as they are easier to deplete.

How speculators profit

There are two main ways that domestic and foreign investors can profit from speculative attacks. Investors can either take out a loan in the nation and exchange the loan for a foreign currency at the fixed exchange rate or short the stocks of the nation prior to the sudden depreciation of the currency.

Taking out a loan allows the investor to borrow a large sum of money from the nation's central bank and convert the money at the fixed exchange rate into a foreign currency. As the massive outflow depletes the war chest or forces the nation to abandon the fixed exchange rate, investors are able to convert their foreign currency back at a significantly higher rate.

For example, an investor borrows 100X and converts it to 100Y at the fixed exchange rate of 1X to 1Y. If the nation X runs out of foreign reserve Y in this period or if they are forced to allow their currency to float, the value of X may drop to an exchange rate of 2X to 1Y. Investors can then exchange their 100Y for 200X, allowing them to pay off the loan of 100X and maintaining a profit of 100X.

An example of this can be seen in the United Kingdom prior to the implementation of the Euro when European countries used a fixed exchange rate amongst the nations. The Bank of England had an interest rate that was too low while Germany had a relatively higher interest rate. Speculators increasingly borrowed money from the Bank of England and converted the money into the German mark at the fixed exchange rate. The demand for the British pound dropped so much that the exchange rate was no longer able to be maintained and the pound depreciated suddenly. Investors were then able to convert their German marks back into pounds at a significantly higher rate, allowing them to pay off their loans and keep large profits.

Shorting stocks also takes advantage of the depreciation of the currency following a speculative attack. Investors sell their stock with the agreement that they will purchase it back after a certain number of days, whether it increases or decreases in value. If an investor shorts their stock prior to the speculative attack and subsequent depreciation, the investor will then purchase the stock at a significantly lower price. The difference between the value of the stock when it was sold and when it was repurchased is the profit that the investor makes. Examples of this can be seen when George Soros shorted Thailand stocks prior to the speculative attack that lead to the Asian Financial Crisis in 1997 and the shorting of Hong Kong stocks during the failed speculative attack in 1998.[ citation needed ]

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 indirectly, by another central bank with an interest in preserving the current exchange rate. As in cornering the market, attackers are left vulnerable.

See also

Related Research Articles

Exchange rate Rate at which one currency will be exchanged for another

In finance, an exchange rate is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country's currency in relation to another currency. For example, an interbank exchange rate of 114 Japanese yen to the United States dollar means that ¥114 will be exchanged for US$1 or that US$1 will be exchanged for ¥114. In this case it is said that the price of a dollar in relation to yen is ¥114, or equivalently that the price of a yen in relation to dollars is $1/114.

Money market

The money market is a component of the economy which provides short-term funds. The money market deals in short-term loans, generally for a period of a year or less.

1997 Asian financial crisis Financial crisis of many Asian countries during the second half of 1997

The Asian financial crisis was a period of financial crisis that gripped much of East Asia and Southeast Asia beginning in July 1997 and raised fears of a worldwide economic meltdown due to financial contagion.

Monetary policy

Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing or the money supply, often as an attempt to reduce inflation or the interest rate, to ensure price stability and general trust of the value and stability of the nation's currency.

In economics, hot money is the flow of funds from one country to another in order to earn a short-term profit on interest rate differences and/or anticipated exchange rate shifts. These speculative capital flows are called "hot money" because they can move very quickly in and out of markets, potentially leading to market instability.

In macroeconomics and modern monetary policy, a devaluation is an official lowering of the value of a country's currency within a fixed exchange-rate system, in which a monetary authority formally sets a lower exchange rate of the national currency in relation to a foreign reference currency or currency basket. The opposite of devaluation, a change in the exchange rate making the domestic currency more expensive, is called a revaluation. A monetary authority maintains a fixed value of its currency by being ready to buy or sell foreign currency with the domestic currency at a stated rate; a devaluation is an indication that the monetary authority will buy and sell foreign currency at a lower rate.

The foreign exchange market is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit market.

The Mexican peso crisis was a currency crisis sparked by the Mexican government's sudden devaluation of the peso against the U.S. dollar in December 1994, which became one of the first international financial crises ignited by capital flight.

Foreign exchange reserves are cash and other reserve assets such as gold held by a central bank or other monetary authority that are primarily available to balance payments of the country, influence the foreign exchange rate of its currency, and to maintain confidence in financial markets. Reserves are held in one or more reserve currencies, nowadays mostly the United States dollar and to a lesser extent the euro.

Impossible trinity Economic impossibility

The impossible trinity is a concept in international economics which states that it is impossible to have all three of the following at the same time:

The Argentine Currency Board pegged the Argentine peso to the U.S. dollar between 1991 and 2002 in an attempt to eliminate hyperinflation and stimulate economic growth. While it initially met with considerable success, the board's actions ultimately failed. In contrast to what most people think, this peg actually did not exist, except only in the first years of the plan. From then on, the government never needed to use the foreign exchange reserves of the country in the maintenance of the peg, except when the recession and the massive bank withdrawals started in 2000.

Floating exchange rate

In macroeconomics and economic policy, a floating exchange rate is a type of exchange rate regime in which a currency's value is allowed to fluctuate in response to foreign exchange market events. A currency that uses a floating exchange rate is known as a floating currency, in contrast to a fixed currency, the value of which is instead specified in terms of material goods, another currency, or a set of currencies.

In macroeconomics and international finance, the capital account records the net flow of investment transaction into an economy. It is one of the two primary components of the balance of payments, the other being the current account. Whereas the current account reflects a nation's net income, the capital account reflects net change in ownership of national assets.

A currency crisis is a situation in which serious doubt exists as to whether a country's central bank has sufficient foreign exchange reserves to maintain the country's fixed exchange rate. The crisis is often accompanied by a speculative attack in the foreign exchange market. A currency crisis results from chronic balance of payments deficits, and thus is also called a balance of payments crisis. Often such a crisis culminates in a devaluation of the currency.

Financial crisis Situation in which financial assets suddenly lose a large part of their nominal value

A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth but do not necessarily result in significant changes in the real economy.

Currency appreciation and depreciation Change of currency values relative to other currencies

Currency depreciation is the loss of value of a country's currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system in which no official currency value is maintained. Currency appreciation in the same context is an increase in the value of the currency. Short-term changes in the value of a currency are reflected in changes in the exchange rate.

Currency intervention Monetary policy operation

Currency intervention, also known as foreign exchange market intervention or currency manipulation, is a monetary policy operation. It occurs when a government or central bank buys or sells foreign currency in exchange for its own domestic currency, generally with the intention of influencing the exchange rate and trade policy.

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.

Sterilization (economics)

In macroeconomics, sterilization is action taken by a country's central bank to counter the effects on the money supply caused by a balance of payments surplus or deficit. This can involve open market operations undertaken by the central bank whose aim is to neutralize the impact of associated foreign exchange operations. The opposite is unsterilized intervention, where monetary authorities have not insulated their country's domestic money supply and internal balance against foreign exchange intervention.

Self-fulfilling crisis refers to a situation that a financial crisis is not directly caused by the unhealthy economic fundamental conditions or improper government policies, but a consequence of pessimistic expectations of investors. In other words, investors' fear of the crisis makes the crisis inevitable, which justified their initial expectations.

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.
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.