Speculative Attacks and Risk Management∗

The paper builds a simple, micro-founded model of exchange rate management, spec-ulative attacks, and exchange rate determination. The country may defend a peg in an attempt to signal a strong currency and thereby boost the government’s future re-election prospects or attract foreign capital. The paper relates the size of the speculative attack and government’s defense strategy to the market’s prior beliefs about the strength of the currency, the ability of foreign speculators to short sell the currency, domestic politics, and initial debt composition. Speculative activities can exhibit strategic complementarity or sub-stitutability. Finally, features of original sin covary with the maintenance of pegs, as letting residents hedge the currency or incentivizing them to lengthen their debt maturity structure is an admission that the currency is overvalued and undoes the signal sent by defending the currency