ERM Presentation Draft

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  • TRAVERS’ INSTRUCTIONS: “In particular, all of these crises were caused by a shock of illiquidity in a derivatives market (or several), as opposed to insolvency. I would like you to summarise the lead-up to the crisis, what caused the meltdown, and what the resulting impact was on the markets. For example, if a trading firm (Soros, LTCM, Enron) were to blame, explain what types of trades they had on that led to the market instabilities. You are welcome to include an explanation of a trading strategy that we have not yet covered in class, if relevent to your story.”
  • ERM, the Exchange Rate Mechanism, was effectively the precursor to the European single currency, the euro.It was a mechanism which required member countries to keep their national currencies, like the pound, within defined and fairly narrow levels against each other.Bands were set 2.5%-6% apart from a central line/entry point; when the fx rate hit those bands, the banks would intervenethe key perceived advantage was that it avoided wide fluctuations in currencies in value against each other. + precusor to euro If you’ve got wide movements in exchange rates it is difficult for people engaged in international trade. Keeping exchange rates more closely aligned was a way of getting round that difficulty.
  • Breakdown of ECU component countriesEmphasise huge share of Germany and France; Germany, for the most part, set the pace for the ERMMark the most stable- all currencies pegged against it
  • East+WestRich, big economy + small, poor economyDeficit as % of GDP 5%-13.2%West German Savings transferred to East Germany; East Germany consumesEast German Mark was converted to the West Mark at a huge rate 1.8:1 (before that, pegged to 1) – far exceeding its value; East German economic shutdown, more DMBurdesbank pumps money in, inflation – interest rates go up 3%Money away from GBP to invest in DMUnemployment at 10%+WorstRecession since WWIILess german money – less germans buy UK things, GBP fallsAbsolute aoppreciatonopfamrkHigher interest artesIf GBP falls with no ERM, less absolute money outflow;
  • George Soros, famous for winning $980 mil+ on falling GBP for his hedge fund; a third was his shareAlso, major banks that won out
  • Sample BB chart, showing the ERM breakdown in action
  • Review of currency/equity/bond price relationships
  • Not a hedge strategy – all trades flow from same assumption (GBP devaluation)
  • Aftermath - effects
  • Three graphs:Negative effectsPie chart – foreign reserves used upFirst bar chart – severe currency devaluationPositive effectsSecond bar charts – UK shows amazing GDP growth despite ERM crisis
  • ERM Presentation Draft

    1. 1. £<br />BREAKDOWN OF THE POUND,GEORGE SOROS,AND GBP ERM WITHDRAWAL<br />Maxim Ogienko – March 18, 2010 – BUS 487G<br />
    2. 2. ERM – A Semi-Pegged System<br />Banks intervene<br />Exchange rate vs. ECU<br />
    3. 3. ECU Components<br />
    4. 4. Precursors of the ERM Crisis<br />West<br />East<br />DM 350MM<br />1DM = 1.8M <br />
    5. 5. – German spending increases<br />German inflation rates increase<br />British inflation levels still three times higher than that of Germany<br />US Dollar rapidly depreciates – many UK exports priced in USD<br />UK and Italy have double deficits<br />Interest rates at 15%, “Lawson Boom” about to bust<br />
    6. 6. George Soros<br />
    7. 7. GBP/DEM X-Rate, 1992<br />3.116<br />2.776<br />September 16,1992<br />Black Wednesday<br />
    8. 8. Traders’ Assumptions<br />Currency must revert to ERM boundaries<br />Britain is reluctant to raise interest rates<br />Interest rates UP – currency rates UP<br />Currency rates UP – equity prices DOWN<br />Currency rates UP – bond prices UP<br />
    9. 9. Soros’ Positions<br />SHORT British Currency – 7bn<br />SHORT Italian Currency<br />LONG British Equities – 500m<br />LONG German Currency – 6bn<br />LONG German and French Bonds<br />SHORT German and French Equities<br />
    10. 10. UK Treasury Response<br />Raising interest rates to 10% - 12% - 15%<br />Spent £27B of foreign reserves in propping up (buying) the pound<br />
    11. 11. £3.4 BILLION<br />Estimated total cost of Black Wednesday [1997]<br />£800 MILLION<br />Estimated Black Wednesday trading losses [1997]<br />
    12. 12.
    13. 13. Aftermath<br />Conservative Party blamed for crisis; loses 1997 election, Prime Minister John Major succeeded by Tony Blair<br />UK leaves ERM<br />Italy and Spain widen ERM bands<br />ECU replaced by euro in 1998<br />ERM-II established in 1999<br />

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