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How did Soros make money by shorting the pound? When he sold the pound and made its price to decrease, he had to buy it back again to return the amount he borrowed, but doesn't buying the pound raise its price, so that he should not make any profit?

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    $\begingroup$ The pound was falling for other reasons than Soros, so he was able to buy them at a lower price than he sold them for. $\endgroup$ – zeta-band Mar 22 at 16:26
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How did Soros make money by shorting the pound?

As a preamble, it is important to keep in mind the context in which this occurred:

  • Two years earlier (in 1990), the UK government had made the controversial and largely political decision of becoming a member of the Exchange Rate Mechanism (ERM);

  • eventually, the macroeconomic reality presented a dilemma to UK policymakers: (1) to devaluate the pound, or (2) to raise interest rates;

  • the UK government discarded devaluating the pound because the extent of an effective devaluation would discredit the UK government's ERM decision and be politically detrimental;

  • but UK policymakers also refused to raise interest rates, since that would strangle UK's already troubled economy and trigger another crisis (e.g., borrowers ending up with negative equity).

Soros was able to close his short position profitably because:

  • when the UK decided to enter ERM, the UK unilaterally chose a sterling/DMark exchange rate which was recklessly high from the start (and impliedly, without anticipation or consideration of complications that could subsequent ensue in the economy);
  • the UK government stubbornly embraced the ERM as the magic solution for its economy, and it ignored the macroeconomic growing disparities between German economy and that of the UK & members of the ERM;
  • the Deutsche Bundesbank decided to raise its interest rates so as to curb the inflation in Germany as well as the costly process of Germany's reunification;
  • the UK ministers' political stand was so arrogant that they naively presumed they could compel the Deutsche Bundesbank to tailor its policies so as to help the UK ministers avoid the discredit and embarrassment for having made the wrong decision as to joining the ERM;
  • after Italy devaluated its currency in 1992, there was mounting pressure or expectation that the UK would have to follow suit due to the systemic imbalances that were ensuing;
  • Soros (or his company) was not the only entity selling/shorting pounds in the critical days of September of 1992;
  • in the morning of September 16, the UK government raised rates from 10% to 12%, thereby fueling the selling of pounds because the markets interpreted the abrupt raise of rates as a sign of weakness;
  • hours later, the UK government desperately raised the rates to 15%;
  • short time later that day, the UK government suddenly desisted from its attempt to keep the pound within the ERM range, at which point the pound went in free fall (also the increase to 15% was withdrawn).

Buying pounds back so as to close Soros's short position simply could not reverse the free-fall of the pound that resulted from UK government's prolonged stubbornness/arrogance and its subsequent, sudden erraticism.

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    $\begingroup$ While this may make for good historical news coverage, there are no explanations of economic principles. $\endgroup$ – Giskard Mar 24 at 14:41
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    $\begingroup$ @Giskard That would require starting from scratch and reproduce here explanations about money supply, inflation, interest rates, bank reserves, and other concepts that surely have been addressed elsewhere (I myself have addressed much of it in other answers I have posted on Economics SE). The OP's reference to Soros ("How did Soros make money by shorting the pound?") suggests that her interest is focused on the [historical] particularities of what culminated in "Black Wednesday", rather than on the general economic principles of ... short selling? currency markets? position volumes? $\endgroup$ – Iñaki Viggers Mar 24 at 14:59
  • $\begingroup$ I am perplexed that someone would upvote your comment, but not your answer :) $\endgroup$ – Giskard Mar 24 at 19:51
  • $\begingroup$ To be clear, it was not me, I disagree with your comment. At the very least you could add links to these "other answers I have posted on Economics SE". $\endgroup$ – Giskard Mar 24 at 19:52
  • $\begingroup$ @Giskard Some links: 1, 2, 3, 4, 5. $\endgroup$ – Iñaki Viggers Mar 24 at 20:51
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When he sold the pound and made its price to decrease

You're assuming incorrectly that Soros was the main driver of the fall in the price of the pound. But that's not what happened. The pound fell (against the Deutsche Mark) because the UK central bank gave up on propping the pound (by buying excess pounds off the market) to the ERM-mandated levels.

he had to buy it back again to return the amount he borrowed

Indeed he had to buy it back, but it was cheaper then.

but doesn't buying the pound raise its price, so that he should not make any profit?

It will raise somewhat, but not as much as it had fallen, because the central bank wasn't trying to return the pound to the old (ERM-mandated) level anymore. Unless the market as whole decided to appreciate the pound to old level, which didn't happen, there was a difference to be pocketed by shorting.

And if you want the real Soros 1992 story, it's more complicated than a simple short selling.

We mentioned that Soros played a complex game. Here's how it went. Soros expected the following: the breakdown of the ERM and a substantial realignment of European currencies; a dramatic drop in European interest rates; a decline for European stock markets.

So, rather than simply shorting the weak currencies, he also placed simultaneous bets on interest rates and securities markets that would be affected by the currency realignments.

In carrying out this operation, Soros and his aides sold short sterling to the tune of about \$7 billion, bought the mark to the tune of \$6 billion and, to a lesser extent, bought the French franc. As a parallel play they bought as much as \$500 million worth of British stocks even while they were shorting sterling, figuring that equities often rise after a currency devalues. Soros also went long German and French bonds, while shorting those countries' equities. Soros' reasoning on the French and German markets was that upward valuation was bad for equities but was good for bonds because it would lead to lower interest rates. [...]

Because of his strong credit, Soros was able to maintain all these positions with just \$1 billion in collateral. He was margined to the eyebrows, but he wasn't really gambling. [...]

Here's how his leveraged positions worked out: The pound dropped 10%, the mark and franc both rose roughly 7%, the London stock market gained 7%, German and French bonds were up about 3% apiece, and the German and French stock markets briefly rallied, but basically remained flat. [...]

FORBES has learned that since early October [1992] Soros has substantially decreased the size of his hedge. He has bought pounds and sold marks to cover most of his short position in sterling.

Basically Soros anticipated correctly most of those short-term movements.

Another fact not mentioned above whas the UK had bluffed with interest rates of 10-15% on Black Wednesday, but (since they were unsustainable due to the poor growth/state of the UK economy), they were quickly cut to around 6% by the end of the year. That alone should tell you that pound had to fall over that period relative to Mark because the economy of the latter was revving up (due to the German reunification which caused both growth and inflation), which caused the Bundesbank to raise interest rates in the same period.

So Soros (and quite a few others) correctly bet that the narrow band of exchange volatility allowed by the ERM was unsuitable to economies with such diverse trends and so that the ERM, which was a political desideratum with poor economic legs, would collapse. The rest is basically details.

Finally it's also a matter of central bank's currency reserves and their willingness to spend them to maintain a (politically mandated) rate; or at least giving the impression that they would. Contrast:

September 16: Black Wednesday: During the day, the Bank of England spent approximately 15 billion pounds in support of sterling, representing roughly 50 percent of the total reserves available to it. Other central banks, particularly the Bundesbank and the Banque de France, bought an additional 5 billion pounds [but the effort ultimately failed]. Britain blamed the Bundesbank for the sterling crisis, charging that Bundesbank leaks suggesting that a realignment was necessary had undermined the position of the pound.

September 18-23: The successful Franco-German defense of the franc. With the outcome of the French referendum in doubt, the franc fell to within one centime of its floor against the D-mark and devaluation seemed imminent. But the tide was reversed by vocal and public support for the franc by the Bundesbank -- "the franc is in no way at risk. The franc is a very strong currency which has achieved inherent stability. On the contrary, it is a candidate for appreciation" -- and an unprecedented coordinated intervention effort. It was later revealed that the Banque de France spent 160 billion francs (\$33.5 billion) of foreign currency in defense of the franc in late September; the Bundesbank was reported to have spent somewhere between 10 to 30 billion marks (\$6.7 to \$20 billion)

To put more simply: where do you think all that money went?

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