Understanding Arbitrage by Randall Billingsley

Author:Randall Billingsley
Language: eng
Format: epub
Publisher: Pearson Education
Published: 2006-01-15T05:00:00+00:00

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George Soros, Currency Speculator: The Man Who Broke the Bank of England4

George Soros is a famous investment manager who started the Quantum Fund in the late 1960s, which was a successful hedge fund.5 His fund earned phenomenal returns from exploiting foreign exchange rate moves. Soros is also known for his philanthropic efforts to develop Eastern Europe. Ever controversial, his wealth has been estimated at around $7 billion. Here we examine one of Soros’s most notable currency speculations—an attack on the British pound sterling in 1992.

Consider the economic context in which Soros speculated against the British pound. Volatility in foreign exchange rates among European trading partners can be costly. Thus, continental European countries had agreed to link their currencies together in an Exchange Rate Mechanism (ERM). Thus, instead of allowing their exchange rates to float freely, the countries agreed to keep rates within a narrow band. The central banks of the member countries would intervene by buying their currency when the exchange rate dropped to a point that might move it out of the band. The trade-off of the ERM was lower exchange rate volatility at the expense of greater government payments.

German reunification in 1989 brought enormous expenditures to revitalize the east. The German central bank raised short-term interest rates in an effort to fight the resulting inflationary pressures. This attracted global investors to the Deutsch mark (DM) and thereby strengthened the currency relative to the other members of the ERM. In an effort to support the pound, Britain raised interest rates, first to 10%, then 12%, and even promised to increase rates to 15%. However, this was particularly onerous to the British economy because so many mortgages are floating-rate, as also are many business loans. Further, Britain announced that it would allocate about $14 billion for purchases of the pound to keep its value within the ERM band. Yet the pound still fell against the DM.

On September 16, 1992, Soros looked at the 15% announced rate in the U.K. and recognized that market forces would ultimately prevail and force the pound out of the ERM band. Thus, on this so-called “Black Wednesday,” Soros sold about $10 billion worth of pounds. He did this by borrowing in pounds and entering forward contracts to exchange those pounds for DMs later. The Quantum Fund exchanged the pounds for DM immediately because the pounds were expected to be cheaper at the delivery date of the forwards. As Soros predicted, the Bank of England attempted to push up the value of the pound with its $14 billion war chest.

Yet it used up all of its money without staunching the pound’s decline. Thus, Britain was forced to leave the ERM. As the pound floated freely, it dropped precipitously against the DM. A common estimate of Soros’s profit is about $1 billion. Hence the oft-used label: the man who broke the Bank of England.

What’s the moral of the story? While we expect interest rate parity to hold and find the framework useful, sometimes government intervention and various market frictions prevent it from doing so.

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