Large Traders, Asset Markets, and Currency Crises

Abstract

During currency crises, large traders once simultaneously short the asset markets and currency market. We study the large trader's information manipulation in crises by introducing a large trader in an asset market and a currency-attack coordination game with imperfect information. The asset price realized in the asset market aggregates dispersed private information acting as a public signal in the currency attack game. We show that the incentive of the large trader to manipulate the asset price in favor of its currency attack leads to the financial contagion. In equilibrium, the large trader's manipulating the asset price to be lower and attacking the currency regime are concurrent; the large trader's manipulation in the asset market is most significant when the public signal is in the intermediate range. To draw policy implication regarding the market transparency, we show that when the asset market is transparent, a natural equilibrium refinement that incorporates forward induction reasoning would select the equilibrium where every trader behaves most aggressively in the currency-attack game and the currency regime is most fragile.