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A Large Trader in Bubbles and Crashes: an Application to Currency Attacks

Author

Listed:
  • Mei Li

    () (Department of Economics,University of Guelph)

  • Frank Milne

    () (Department of Economics,Queen's University)

Abstract

Abreu and Brunnermeier (2003) study stock market bubbles and crashes in a dynamic model with a continuum of rational small traders. We introduce a large trader into their model and apply it to currency attacks. In an attack against a fixed exchange rate regime with a gradually overvaluing currency, traders lack common knowledge about the time when the overvaluation starts. Meanwhile, they need to coordinate to break a peg. In such a setup, both the inability of traders to synchronize their attack and their incentive to time the collapse of the regime lead to the persistent overvaluation of the currency. We find that the presence of a large trader with perfect information will accelerate the collapse of the regime and alleviate currency overvaluation. However, if a large trader has incomplete information, the presence of a large trader may accelerate or delay the collapse of the regime ex post, depending on the size of his wealth and the precision of his information. More specifically, we find that a large trader with both a large amount of wealth and very noisy information can greatly delay the collapse of the regime ex post. Moreover, we find that the presence of a large trader with incomplete information can greatly increase the unpredictability about the time when the regime collapses, implying the difficulty for traders to time the collapse.

Suggested Citation

  • Mei Li & Frank Milne, 2010. "A Large Trader in Bubbles and Crashes: an Application to Currency Attacks," Working Papers 1004, University of Guelph, Department of Economics and Finance.
  • Handle: RePEc:gue:guelph:2010-04.
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    File URL: http://www.uoguelph.ca/economics/repec/workingpapers/2010/2010-04.pdf
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    References listed on IDEAS

    as
    1. Dilip Abreu & Markus K. Brunnermeier, 2003. "Bubbles and Crashes," Econometrica, Econometric Society, vol. 71(1), pages 173-204, January.
    2. Christophe Chamley, 2003. "Dynamic Speculative Attacks," American Economic Review, American Economic Association, vol. 93(3), pages 603-621, June.
    3. Giancarlo Corsetti & Paolo Pesenti & Nouriel Roubini, 2002. "The Role of Large Players in Currency Crises," NBER Chapters,in: Preventing Currency Crises in Emerging Markets, pages 197-268 National Bureau of Economic Research, Inc.
    4. Bannier, Christina E., 2005. "Big elephants in small ponds: Do large traders make financial markets more aggressive?," Journal of Monetary Economics, Elsevier, vol. 52(8), pages 1517-1531, November.
    5. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2009. "Carry Trades and Currency Crashes," NBER Chapters,in: NBER Macroeconomics Annual 2008, Volume 23, pages 313-347 National Bureau of Economic Research, Inc.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Large Trader; Bubbles and Crashes; Currency Attack;

    JEL classification:

    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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