The actual statistics and regression of Black Wednesday

Data was taken from DataStream Advance version 3.5 and the estimation sample covers the period from January 1985 to September 2000.Estimation: the results were given by OLS methodology and IV estimation using PC-Give.

The most interesting figure is perhaps the coefficient of variation of inflation rate. During pre –ERM, the influence of the inflation rate was the greatest one compared to the rest with 0.29. Moreover, during the short period the UK pegged its sterling to Deutsch Mark, the coefficient of variation of inflation rate reached 0.25 associated by the highest average of 6.4. Albeit, the following period saw more stable circumstances with 0.13 and around 0.35 in coefficient of variation and standard deviation of inflation rate respectively. It can deduce that the UK monetary policy has been becoming more stable after ERM and the Black Wednesday.

From 1985 to 1991, the UK LIBOR seemed to dominate both US and Germany. But the condition did not last long because just in the year of Black Wednesday, 1992, the German cut over UK LIBOR line at just under 13% and had kept the highest position until the end of 1994. To explain the change, George Soros is likely the best answer.

The difference existed obviously between the Pre-ERM and Post-ERM Reaction function line. While before 1990, the reaction function line tended to stick on actual interest rate, and therefore, the regression could explain robustly the actual interest rate from 1985 to 1990. It can say that during pre-ERM, the British Government monetary policy followed market free forces.

But the Black Wednesday was one of the main reasons that turned the reaction function to unbounded circumstance before 1992, post-ERM reaction function. However, the dash line tended to stick on the actual interest rate after 1992. This implied that the monetary policy of British Government had corrected its fail as the table above showed.

Reference:
The article used figures and table from dissertation of Christopher Adam et al, 2011,“External influences and institutional constraints on UK monetary policy, 1985-2000”.

What did they talk about Black Wednesday, Mr Soros?

The head of Soros Fund Management, Scott Bessent (Bessent Capital), had said that: “Interestingly, no one had ever heard of George Soros before this. I remember going to play tennis with him at his London house on the Saturday after it happened. It was as if he was a rock star with cameramen and paparazzi waiting out frond”

As can be seen from the figure, the UK base rates had an extreme artificial increase on September 16th,1991. There was no plausible reason but the British Government attempted to create an artificial exchange rate. They thought that the 12% interest rate and a promise hiking up to 15% with the aim of making the pound more expensive to borrow. However, after the abnormal event, the interest rate became usual accomplished by the announcement to quit EMR.

Is this a W shape written by the Black Wednesday? It seems to be rarely W-shape technical analysis so far, perhaps there has been little number of similar events happen. Someone could wish that if he could go back in 1992, he would have earned more money than Mr George Soros. But actually, there was another chance for speculators during 1996 and 1997, when the exchange rate DeM/£ recovered and even more than 1992. What if George Soros could more certain about this? As a guess, the Bank of England and tax payers would be very happy that Soros did not do so. Indeed, after 1992, he attempted to perform some risky investment, and lose several million dollars consequently.
Reference: Stephen Drobny et al. (2009), Inside the house of money: top hedge fund traders in profiting in the Global Market.

Black Wednesday inside view 2

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.
 

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).

(to be continued)

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 12^th, 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.

Question to The man who broke the Bank of England: Who was your accomplice?

http://news.bbc.co.uk/1/hi/business/4249425.stm