Speculative attacks

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 adapted their mechanism to explain speculative attacks in the foreign exchange market.

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.

A speculative attack in the foreign exchange market refers to 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 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. In order to maintain a fixed exchange rate, the nation’s central bank must hold a massive amount of foreign reserve that can be used to purchase the nation’s own currency at a fixed price.

If foreign or domestic investors believe that the central bank does not hold enough foreign reserve to defend the fixed exchange rate, they will target this nation for a speculative attack. The investors do this by selling their local currency to the central bank at the fixed price in an attempt to deplete the central bank’s foreign reserve. Once the nation runs out of foreign reserve, the central bank will no longer be able to purchase local currency at the fixed exchange rate and the currency is allowed 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.

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