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Speculative attack

From Wikipedia, the free encyclopedia

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). 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.

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  • Speculative attack on a currency | Foreign exchange and trade | Macroeconomics | Khan Academy
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Transcription

Voiceover: Let's revisit the scenario where everyone is trying to exit country B's currency and convert it back into country A. We saw in the last video that if, just left to its own devices, if this were to happen, if lot of Bs wanted to converted into currency A and because everyone is afraid to convert into B now because they think for whatever reason the country B is in bad shape, then you have this imbalance and if you left it to its own devices, country B's currency would become devalued. You would need more Bs to trade for an A, which is just another way to say B's value would go down, and that could be a bad thing, especially if it's a pretty steep decline. Maybe it's a country that needs to import fuel from the rest of the world. Maybe they need to import food from the rest of the world, and if their currency were to devalue dramatically, then imports could become very, very, very expensive and so people in that country might have to pay double for gas and double for basic necessities like food and whatever else. So we played out a scenario where the central bank of country B actively tries to intervene to keep this from happening, to keep the exchange rate stable, and so what they do is they could use reserves, and I'll do this in blue for country B, so they could use reserves of A that they have accumulated during better times or in previous videos, depending on how you want to view them, and they try to balance out the supply of A's with the supply of B's by selling their reserves and buying B's. So one way to think of it, they're adding supply of A's and they're also adding demand for B's. They're going to sell their reserves of A and buy their own currency. And that would work as long as they have reserves. They're going to be able to stabilize things so that this situation doesn't happen. But the problem was, and we talked about it at the end of the last video is that they can run out here. It's not like they can print another country's currency forever. They can't print it at all. They have to accumulate this. This isn't their own currency. So they have a finite amount of this. They could eventually run out. What is often the case is, currency speculators see this and they begin to smell blood. They see, okay look, people are trying to exit this currency. It would devalue if it was left to its own devices, but the central bank of country B is trying to keep it from devaluing by depleting its finite reserves of currency A. So what currency speculators will start to do is, well I can go into country B and I can borrow B's. So I could literally go to a bank in country B and borrow some of the B currency, and then I could go to the exchange markets and try to convert it into A's. Just off of looking at that superficially, what's that going to do? Well this is going to make the situation even worse for the central bank, because now you have people actively that don't even hold B's before they're going to be borrowing B's and converting them into A's. So it's going to create an even larger supply of B's and even more demand for the finite number of A's that are willing to go this way. And why is the speculator doing this? Well think about the two situations for them. Let me draw the two scenarios. Scenario one is that for whatever reason the central bank of B is able to keep the currency stabilized. So currency stays stable. And the other scenario is that the central bank runs out of reserves, and they have to essentially just let the currencies float, and B gets devalued. So central bank out of reserves, which would mean that the currencies would float and B would devalue. Well if this first scenario happens, and it's happens, and it's going to become less and less likely as more and more people pile on this strategy and more and more people try to run out of B's or try to exit B's currency. But even if this situation were to happen, the speculator says okay, the currency ended up being stable. I'll just unwind this. I'll take my A's, when I have to pay off my debt in B's, I'll take my A's, convert them into B's and pay off my debt. And so depending what the interest rates and all of that were, not a big loss or maybe even a minimal loss, and only if there's a kind of differential with interest rates or things like that, minimal to no loss. But what happens if the central bank runs out of reserves? Remember just the fact that the speculators are doing this speculative attack, they're borrowing in country B and converting to A, that's making the central bank run out of reserves even faster. It's going to deplete their reserves. Essentially when they do this, it's the central bank of country B that's going to be giving them, is going to be allowing them to convert. They don't know who they're buying these B's from with this A currency they have. So if this happens, if the central bank runs out of reserves, it floats, and then B devalues, then those currency speculators make a pretty good buck. and just to see how that could work, imagine that they borrow 100 B's, so this is what they borrow, and while the currency is being actively intervened with by the central bank, they're trying to keep it from devaluing, the exchange rate is one A for one B, so they convert on the open market, and the only reason this is able to happen at this exchange rate is because B's central bank is actively selling A's, they're able to convert to 100 A's. Now let's say that they're able to do this and the central bank runs out of A's and then a devaluation occurs. So this is happening at a conversion of one A equals one B. But let's say that these guys, they run out of reserves. The things devalue. B becomes worth a lot less, and then we go to a future state where one A is now equal to two B's. Well as soon as this happens, and remember this is this scenario right over here that we're thinking about right over here, this is what the currency speculators want to happen. If one A all of a sudden equals two B's because the central bank can't intervene any more, they are floating, B gets devalued. Then what's going to happen? These guys can take their 100 A's. Convert it back once things are floating. So now they're going to convert back into this direction. And how many B's can they convert it into? Well now they can convert it into 200 B's. They can pay off their debt because they borrowed the 100 B's, so minus 100 B's to pay debt, and then they make a pretty sizable profit. They make a profit of 100 B's. That's exactly what they're hoping for, and so you can imagine this is one of those trades that they're going to try to get more and more people to do, because the more people that jump on the band wagon and do this exact same strategy, the faster the central bank's reserves are going to deplete, and the more likely that this situation right over here plays out.

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 sterling dropped so much that the exchange rate was no longer able to be maintained and sterling depreciated suddenly. Investors were then able to convert their German marks back into sterling 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

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 was last edited on 19 July 2023, at 01:38
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