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Black Wednesday and Lonely Britian

Discussion in 'Economy/Finance stuff' started by Chaupham, Aug 30, 2012.

  1. Chaupham

    Chaupham Member MBA Family

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    One man had got $1 billion. One bank had a bill of £28 billions. One day saw an extraordinay event in historic banking finance.
    From my blog : http://chaup.blogspot.co.uk/2012/02/so-soros-who-are-you-and-what-happened.html

    Part 1

    So Soros, who are you and what happened

    Someone could be written on special most-wanted notification (dead or alive) for the so-called name: The man who broke the Bank of England. However, the name was given admired to George Soros after he made a quick but extraordinary fat profit, which was approximate £1 billion from exploiting the British Government’s monetary policy.

    WHO IS GEORGE SOROS?
    Mr George Soros was born in August 12th, 1930. His early life saw violent wartime during 1940s and he found himself immigrating to England in 1947. After graduating at London School of Economics, he left England for American Dream with a luggage stuffed with 9 – year working experience and a great influence from his lecturer, philosopher Karl Popper. A hard life perhaps makes man stronger, and the successful financer seems to be not an exception.


    WHAT WAS HAPPENING AT THAT TIME?
    After suffering from variable exchange rate so many years, European countries achieved a consensus about introducing European Exchange Rate Mechanism (ERM) in March 1979. Isolated by sea but close economics to the rest European friends, lonely England’s currency - sterling quickly felt into its friends’ arms by entering ERM in October 1990, but did not know that the gloom of economics had been waiting for it. The contract although allowed sterling to be stable in comparison with the rest, it constrained the currency from fluctuating more than 6% among other member currencies. As its integrity, British monetary policy obeyed strictly the rule even though it was suffering from so many difficulties. While British inflation level was nearly three times higher than Germany, the exchange rate was DEM 2.95/£ indicating that the sterling was overvalued. But it was not the end of Ho Chi Minh trail, as Germany added difficulty to British policy-makers by its high interest rate. Exogenously, foreign speculators had been exploiting the sensitive trouble of the European family. In the end, whatever difficulties the British Conservative Government had to face, it did not matter anymore, and Prime Minister John Major put a full-stop for the relationship with ERM in 1992.
     
  2. Chaupham

    Chaupham Member MBA Family

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    Part 2
    Black Wednesday inside view

    Given the profit of $1 billion in a couple of days by short selling sterling for US dollar, every investor must doubt whether there is an illegal underlying affair or not. In the case of Black Wednesday, the questions raised were why the Bank of England was forced out the ERM in 1992 and what Mr George Soros did.

    The Bank of England’s perspective

    As the action was performed based on financial speculation, it is crucial to revise the basic theory related to currency market. In 1990s, ERM imposed a limitation band that constrained monetary exchange fluctuation between each other of 2.5% on all members (except Italia, which was permitted a fluctuation of 6%). This implied the basic structure of exchange rate system from European Monetary Union (EMU): crawling peg (or semi-pegged system). In the structure, inflation must be similar to the pegged currency “shadowing” Deutsche mark (DE) and intervention will be unlimited assistance on the credit line. However, the sterling was thrown to the money basket of EMU without careful consideration. Consequently, in 1992 the pound entered the mechanism at DE2.95/£ with allowed fluctuation band of (2.87, 3.02).

    The very first trouble turned out to be relative greater British inflation compared to Germany. To have an inside view, a theory analysis is necessary. Fisher (1930) said that nominal interest rate should reflect expectations of the rate of inflation.

    In formulae, the nominal interest rate is a sum of expected real interest rate and expected rate of inflation: I(t) = Ie + π e .

    To understand the inflation, the interest will make a great sense. In 1990, the reunification of East and West Germany created waives on European politics and economics. Especially, the German government decided exchange rate between Ostmarks and Deutsche to be 1:1, as an attempt to get Eastern Lander joined German economics even though power purchase parity (PPP) of Ostmarks was less than PPP of Deutsche marks. Hence, the German government announced a tight monetary policy of low money growth and high interest rate. However, this policy was not good news for sterling, which was suffering from high interest rate at that time, that was almost three times more than Germany’s. Indeed, the British interest rate was at a high level of around 10%, but then in September, 1992 they hiked the rate up to 12%, even 15% according to a promise of UK’s Prime minister and cabinet members. Why they increased the nominal interest rate although it was supposed to be decreased? One reasonable answer is that they tried to tempt speculators to buy pounds. However, the speculators who had never been naïve did find a sign of fat cheese, and accelerated their investments by selling pounds. By 19:00 pm September 16, 1992, Norman Lamont, announced Britain would leave the EMR, kept the rate at 12%. There was no sentence from speculators; perhaps they were so busy counting the fat profit. (The next day the interest rate was back on 10%, anyway).

    George Soros’s perspective

    Obviously, he is a speculator, who gave Bank of England the Black Wednesday. The action he performed at that time has been raising the curiousness of financial lovers. He simply sold local currency (sterling) and buying foreign currency (US dollar). The trading led central bank to lose foreign reserves to defend the peg’s band and force them to abandon peg. In other words, the British inflation would be unwanted increased in compare to German’s inflation, if interest rate was maintained, sterling would appreciate. One attractive point was that the law of one price was seriously violated. In detail, the law of one price is as the following:

    The formulae,

    (I - I*) / (I+1) = (F - S) / S

    With i is domestic interest rate, i* is foreign interest rate, F is future price and S represents for spot price. In addition, banks always charge fee, differentiate the price of bid and ask and take upper hand situation.

    Someone may ask whether the action was a speculating through Money Market or Forward Market. To some extent, it does not matter because Money Market is just the Forward contract under Covered interest rate parity. To understand the speculating, it is a good idea to revise currency forecasting techniques. There are two techniques: fundamental exchange rate forecasting, whose brief idea is that if GDP increases x%, the domestic currency will depreciate relative to the foreign currency by b multiplied by x%; and technical analysis, which based on past trading behaviour and past exchange rate trends. However, the event of Black Wednesday can be a combination of the two techniques.

    Firstly, the accuracy of a speculating can be described as:
    E(t+k) = S(t+k) – S^(t+k)

    With S is the actual expectation and S^ is the forecasting at time k.

    According to Messe and Rogofl (1983), the forecasting models and benchmarks can be given by considering the random walk
    S^(t+k) = S(t)

    And the unbiasedness hypothesis
    S^(t+k) = F(t+k)


    The two formulas can be deriviated to take the level of interest rate according to Messe and Prins (2011)
    S(t) = (1+i*) / (1+i) + E[S(t+1)]

    Then it can be taken log to have the logarithm of the level of the exchange rate
    Ln[S(t)] = I*(t) – i(t) + Et[ln[S(t+1)]]


    So Engle and West (2005) said that if the discount factor close to 1, once again the random walk exists: Ln[S(t)] = E[ln[S(t+1)]] , and Engle at el (2007) confirmed the result.

    Therefore, it seems to be true that the best predictor for future exchange rate is today’s exchange rate. But the conclusion is not very related to what Soros did. Maybe he considered another way: financial news.

    To explain why there were so many speculators in 1992, Krugman (1979) and Flood and Garber (1984) had noted that speculators always love to attack any government, whose policy is inconsistent with its currency peg. In this case, British government had been really inconsistent. The decision that allowed sterling to join EMR was controversal at that time, even Chancellor of the Exchequer - Nigel Lawson had resigned due to the conflict with Margaret Thatcher’s economic adviser Alan Walters. And according to Clarida and Waldman (2008), the exchange rate should be expected to appreciate if the government hikes interest rates in response to positive inflation news. Indeed, there were not only Mr George Soros but also so many speculators earned profit from the Black Wednesday. But history recorded him as the man who earned the highest profit, and the man who broke the Bank of England.
    Reference: Bekaert and Hodrick, International Financial Management, 2nd edition, Pearson Education, 2011.
     

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