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Can somebody explain this to me? I don't get how leaving the exchange rate mechanism made Soros a winner.

jordanb 16y ago
Soros sold shorts against the British pound, essentially, betting that it would fall in value. The Bank of England tried to keep the value of the pound high enough to stay within the 'allowed band' of the ERM by buying up the excess pounds (and the bullish side of Soros' short contracts) on the open market, using their foreign currency reserves. If the bank had allowed the pound to fall instead of trying to prop it up though, Soros wouldn't have had a buyer. Moreover, if Soros had lost his nerve or his solvency selling shorts before the BoE ran out of reserves, the pound would have stayed high and he would have lost his shirt fulfilling the contracts. Once Soros sold his contracts, he stood to lose if the value of the pound stayed high. The Bank of England could keep it high even after their attempts to buy up pounds had failed, by drastically raising interest rates and keeping them high. That would have thrown the British economy into a recession so Soros was betting that the BoE wouldn't go through with it. In the end, the BoE didn't have the nerve to jack interest rates, so they let the value of the pound fall out of the ERM-allowed band, and Soros was able to fulfill his contracts with cheap pounds and pocket the difference.
- cstross 16y ago
  They did try to jack the interest rates (full disclosure: I'm British and I had a bank account at the time :) -- the base rate rocketed by roughly 1% one day, then 2% the next. Then they chickened out and pulled the eject handle on the ERM, and cut the base rate back to where it had been before Soros' assault. That was the moment when it became obvious that the next government would be a Labour one. (And the reason Labour instantly hived the BoE off as an autonomous entity.)
jakarta 16y ago
At the time, Germany and England had economies that were quite different. Germany had to still deal with the effects of their reunification, England had high levels of inflation (much higher than Germany's) and a high deficit. Usually when you peg an exchange rate, you want economies that are similar and will be going in similar directions. This is pretty rate to pull off, essentially you are dictating your monetary policy to another nation's central bank. The exchange rate mechanism kept the pound artificially high by forcing the Bank of England to intervene whenever there was selling pressure. That way the pound would not devalue below the 1:2.95 level. Similarly, raising interest rates would have been a non-starter too because it might lead to the pound exceeding the 1:2.95 level. With Soros selling at such a great magnitude, Billions versus hundreds of millions, he was able to force England to stop using the mechanism and let the pound float to a lower price which more accurately reflected its true value.
- cturner 16y ago
  Does shorting an economy cause inflation? I have this idea that when you short you're increasing the volume of money in the system.
  - jakarta 16y ago
    No, you are just borrowing a lot of the money that already exists and then you are using your large volume and sell order to put downward pressure on the security's price.
zmmz 16y ago
http://en.wikipedia.org/wiki/Soros#Currency_speculation http://en.wikipedia.org/wiki/Soros#Currency_speculation Basically, he took 10 billion British Pounds and exchanged them for other currencies (Deutsche Marks mainly if I remember correctly). Since the pound was already less desirable due to lower interest rates it triggered a snowball effect and many people followed suit. The Pound left the ERM, and plummeted in value since everybody was selling at that stage. With the pound on the cheap, Soros then bought the bound back with his Deutsche Marks, except that this time around he got a lot more then the 10 billion which he sold as the Pound was cheaper to buy.

Soros sold shorts against the British pound, essentially, betting that it would fall in value. The Bank of England tried to keep the value of the pound high enough to stay within the 'allowed band' of the ERM by buying up the excess pounds (and the bullish side of Soros' short contracts) on the open market, using their foreign currency reserves. If the bank had allowed the pound to fall instead of trying to prop it up though, Soros wouldn't have had a buyer. Moreover, if Soros had lost his nerve or his solvency selling shorts before the BoE ran out of reserves, the pound would have stayed high and he would have lost his shirt fulfilling the contracts. Once Soros sold his contracts, he stood to lose if the value of the pound stayed high. The Bank of England could keep it high even after their attempts to buy up pounds had failed, by drastically raising interest rates and keeping them high. That would have thrown the British economy into a recession so Soros was betting that the BoE wouldn't go through with it. In the end, the BoE didn't have the nerve to jack interest rates, so they let the value of the pound fall out of the ERM-allowed band, and Soros was able to fulfill his contracts with cheap pounds and pocket the difference.

cstross 16y ago
They did try to jack the interest rates (full disclosure: I'm British and I had a bank account at the time :) -- the base rate rocketed by roughly 1% one day, then 2% the next. Then they chickened out and pulled the eject handle on the ERM, and cut the base rate back to where it had been before Soros' assault. That was the moment when it became obvious that the next government would be a Labour one. (And the reason Labour instantly hived the BoE off as an autonomous entity.)

jakarta 16y ago

At the time, Germany and England had economies that were quite different. Germany had to still deal with the effects of their reunification, England had high levels of inflation (much higher than Germany's) and a high deficit. Usually when you peg an exchange rate, you want economies that are similar and will be going in similar directions. This is pretty rate to pull off, essentially you are dictating your monetary policy to another nation's central bank. The exchange rate mechanism kept the pound artificially high by forcing the Bank of England to intervene whenever there was selling pressure. That way the pound would not devalue below the 1:2.95 level. Similarly, raising interest rates would have been a non-starter too because it might lead to the pound exceeding the 1:2.95 level. With Soros selling at such a great magnitude, Billions versus hundreds of millions, he was able to force England to stop using the mechanism and let the pound float to a lower price which more accurately reflected its true value.

cturner 16y ago
Does shorting an economy cause inflation? I have this idea that when you short you're increasing the volume of money in the system.
- jakarta 16y ago
  No, you are just borrowing a lot of the money that already exists and then you are using your large volume and sell order to put downward pressure on the security's price.

zmmz 16y ago

http://en.wikipedia.org/wiki/Soros#Currency_speculation http://en.wikipedia.org/wiki/Soros#Currency_speculation Basically, he took 10 billion British Pounds and exchanged them for other currencies (Deutsche Marks mainly if I remember correctly). Since the pound was already less desirable due to lower interest rates it triggered a snowball effect and many people followed suit. The Pound left the ERM, and plummeted in value since everybody was selling at that stage. With the pound on the cheap, Soros then bought the bound back with his Deutsche Marks, except that this time around he got a lot more then the 10 billion which he sold as the Pound was cheaper to buy.