Speculative attack


Speculative attack

A speculative attack 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.

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

References

[http://www.bportugal.pt/publish/bolecon/docs/2003_2_3_e.pdf] Bank of Portugal report on the defense of the Portuguese Escudo in the European exchange rate mechanism

[http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-36.html] Federal reserve bank of San Francisco article on the failed attack on the Hong Kong dollar

[http://www.imf.org/external/np/leg/sem/2004/cdmfl/eng/takagi.pdf] IMF report on emerging market currency crises

ee also

*Speculation in financial markets


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