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.