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The Trade Of The Century

Pratham currently pursuing his Bachelor's in Business Administration really loves the field of finance and would like to share his opinion :

Introduction

A financial market is a place where few make a fortune and many make losses in hope of a fortune. George Soros was one such man who managed a Hedge Fund in the early 1990s, he was known to advise the hedge fund named The Quantum Fund.

This man, however, brought The Bank Of England to its very knees by just a single trade. A trade where he made a personal fortune of 1 billion USD. The trade which was later dubbed as the ‘Trade of the century

the-trade-of-the-century

The Suffering

This story begins in the year 1992, a time when the world was at peace but the economies around the world were suffering. England was one such country. Facing rising inflation and unemployment within the country.

To fend off this disturbance and to prevent any impending disaster the bank launched a policy of pegging its currency against the German DeutscheMark (The currency at the time, however in 1999 the country became part of the Euro System making its official currency as Euro).

Germany at that time was booming on the fruits of industrialization and the economy was soaring to new heights. The bank of England saw the numbers and decided to follow the example in hope of achieving the same output.

They, couldn’t have been more wrong.

The Pegging

Pegging or fixed exchange rate is a practice used by Central Banks to tie the value of one currency with another as a fixed and predetermined range where the bank will intervene if the pegging range is broken.

Bank of England used this very practice with German Deutschemark. But why was the Bank of England so quick to take this step?

The reason was political of course.

In England, the political term lasts 5 years for a Prime Minister. The PM at the time of the election in 1987 was Margaret Thatcher. Margaret Thatcher, however, stepped down from office after losing support and John Major was elected as the successor.

John Major like every politically elected candidate wanted to continue his reign. With elections in 1992 just around the corner, he had to show growth, or he would lose support.

Germany and ERM

The growth spree that spanned years was now coming to a halt when 1991 arrived as the country saw inflation brought about due to rapid expansion.

The German central bank decided to increase interest rates to fight inflation. Much like how the Central banks around the globe are now frantically increasing interest rates to fight inflation.

The rising interest rates made investing in the country favorable as higher interest rates meant higher returns. This led to the value of Deutshemark rising.

The problem for Britain now began as its economy was struggling and as per Europe Exchange Rate Agreement or ERM that it signed in 1991. The country had to use its foreign reserves to keep up with the peg.

The country had to increase interest rates to make it an attractive investment for investors, but this in return scared them away as investors pulled out of the country, putting downward pressure on the pound.

The situation took another turn for the worse when the pound fell due to British investors selling their stakes and investing in German companies.

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The Opportunity

George Soros saw an opportunity as the Bank of England was frantically buying pounds to keep up with the peg. Soros knew the currency is overvalued in comparison to the German Mark. So, he decided to take a short position in the market.

Short Selling is a practice where an investor sells the share he borrows from another investor in the market. The speculation occurs that the value of that share will fall in the market in the near future when the one who borrowed the share will buy the share at this new value and return it to the original owner.

If, the Selling price> New price -> Profit

If, the Selling Price < New Price -> Loss

Soros speculated that the value of the pound will fall in the future.

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Hit Where It Hurts

Soros to plan his short position had to make investments which he did. He invested 40% of the entire capital of his company (Roughly 5 billion USD) in a single trade which was unheard of before. He later went on to invest his personal fortune in the cause.

The Bank Of England had 19 billion USD worth of reserves for defending the currency which was enough to even fend off Soros’s attempt to short the Pound.

Soros decided that to make a profit he needed more investment. He visited a few fellow hedge fund managers and traders and provided them with the information which led to them taking a short position as well. This led to even more downward pressure on the currency.

Response

The Bank of England was now forced to increase interest rates from 10% to 12% to attract investment in the country. This just like before scared the investors away as the market thought that the country might be on the verge of defaulting.

The pressure on the pound rose to the extent that the bank within the same day increased interest rates to 15%. The action devasted the bank as the pride it held shattered. The Bank of England was forced to abandon the ERM system.

The day was later dubbed ‘The Black Wednesday’

An announcement on 16th Sept 1992 was passed that the interest rates are now back to 12%.

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Conclusion

Britain tried to defend the currency until the last moments. But the 800 basis points change in interest rates in a single day sounds too crazy to believe to this day.

George Soros made 1 – 1.5 billion USD worth of that single trade. His firm made 7 billion dollars from the entire deal.

This led to George Soros’s name being written down in history as one of the greatest investors and the man who brought the Bank Of England to its very knees.

Stay tuned for more insights :)

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2022 Pratham Arora

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