Currency Speculation Game

– Nash Equilibrium
Abhishek Khurana (251), Chitrang Bohra (261), Praneeta Pokkuluri (283), Shailaja Y (295)

What is Game Theory?

Game theory attempts to take into consideration the interactions between the participants
and their behaviour to study the strategic decision-making between rational individuals.
The actions of the players are interdependent and changes they determine the output of
the game. The games can be broadly classified into two categories: zero-sum and non-zero-
sum.
• In zero-sum games, the loss of one is gain of another.
• It is not the case in non-zero-sum games, there can be a net gain or net loss

The ‘Nash Equilibrium’

Mixed-strategy Nash equilibrium has applications in a wide variety of fields. It can
capture the spirit of surprise in games where players are unpredictable. For instance, it
can improve our understanding of speculative attacks, which are typically sudden and
unexpected.
On “Black Wednesday” – 16 September 1992 – in a sudden speculative attack
investor sold massive amounts of British pounds with the anticipation of a devaluation (a
drop in the value of the pound against other currencies). At the time, the value of pound
was fixed by the Bank of England against other European Union currencies. On the day,
the Bank bought £4 billion to keep the pound from losing value. However, unable to resist
the market forces, the next day the Bank let the value of the pound fall by more than 10%.
Speculators who had sold pounds and purchased German marks just one day earlier
made huge profits. The Bank made huge losses. One of the large speculators, Hungarian-
American businessman George became “the man who broke the Bank of England”.
How to make sense of Black Wednesday? Why didn’t the Bank of England devalue
the pound a day before the attack to avoid massive losses? For the investor, it is best to be
unpredictable about when to engage in a speculative attack. If the central bank could
predict the attack, the bank would pre-emptively devalue its currency the day before the
attack to avoid losses. The speculators would then be too late to take advantage of the
devaluation.
There is no pure-strategy Nash equilibrium in the Currency Speculation Game. Just
like in the Rock-Paper-Scissors Game, the only equilibrium in the Speculation Game is in
mixed strategies. Speculators randomise the timing of the attack so that the central bank
cannot predict the exact date of the speculative attack. This explains why the Bank of
England was unable to pre-empt the speculative attack on Black Wednesday.

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