Financial Markets and Institutions (2-downloads)

Profiting from a Foreign Exchange Crisis

Large banks and other financial institutions often conduct foreign exchange trad-

ing operations that generate substantial profits for their parent institution. When a

foreign exchange crisis like the one that occurred in September 1992 comes along,

foreign exchange traders and speculators are presented with a golden opportunity.

The foregoing analysis of this crisis helps explain why.

As we saw in Figure 16.3, the high German interest rates resulted in a situation

in which the British pound was overvalued, in that the equilibrium exchange rate in the

absence of intervention by the British and German central banks was below the lower

exchange rate limit of 2.778 German marks per British pound. Once foreign exchange

---

388

Part 5 Financial Markets

traders realized that the central banks would not be willing to intervene sufficiently

or alter their policies to keep the value of the pound above the 2.778-mark-per-pound

lower limit, the traders were presented with a “heads I win, tails you lose” bet. They

knew that there was only one direction in which the exchange rate could go—down—

and so they were almost sure to make money by buying marks and selling pounds.

Our analysis of Figure 16.3 reflects this state of affairs; another way of looking at 

this one-sided bet is to recognize that it implies that the expected return on mark-

denominated deposits increased sharply, shifting the R

F

schedule to in Figure 16.3.

Savvy foreign exchange traders, who read the writing on the wall early in

September 1992, sold pounds and bought marks. When the pound depreciated 10%

against the mark after September 16, they made huge profits because the marks they

had bought could now be sold at a price 10% higher. Foreign exchange traders at

Citibank are reported to have made $200 million in the week of the September 1992

exchange rate crisis—not bad for a week’s work! But these profits pale in comparison

to those made by George Soros, an investment fund manager whose funds are reported

to have run up profits of $1 billion during the crisis. (However, Soros gave some of these

profits back in 1994 when he acknowledged that he had suffered a $600 million loss

from trades on the yen.) Clearly, foreign exchange trading can be a highly profitable

enterprise for financial institutions, particularly during foreign exchange rate crises.

C A S E