currency speculation 101

But first, a quick primer on short-selling and its application to currency speculation:

Short-selling, simply put, is the process by which you sell something that you do not own. Typically, this is stock, but it can also be currency, as we will see later. Short-selling goes against the “buy low, sell high” logic that most associate with the stock market (known as “selling long”). Instead, it involves borrowing stock, for a fee, from a broker. You then sell this stock, hoping that the price of the stock drops before you must return the stock to its owner. You then buy back the stock at its lower price (at a profit) and return it to its owner.

The reason that selling short is seen as riskier than selling long is that because when you buy a share of stock at $50, the maximum risk to you is $50, because the price can only drop to $0. However, when you short-sell that same stock, there is no limit to how high the price of the share can rise (instead of falling, as desired). Hence, the potential for your loss is without limit.

For this reason, short-selling alone is typically a luxury of the wealthy, however a combination of short-selling and long-selling is often used to “hedge the bets” of both, in what are aptly named “hedge funds”.

This is the strategy that Soros used to make nearly a billion dollars and generate international publicity as possibly the most famous financial speculator ever. How did he do it?

In 1992, the United Kingdom joined the ERM, which was a system of fixed exchange rates as a precursor to the introduction of the euro. Because of the disparity between the economy of the UK and the countries to which its currency was pegged, popular support for ERM membership was waning. Due to this, and other factors, most economists considered the Pound to be overvalued. George Soros saw this as the opportunity of a lifetime.

Using his extensive financial resources, he very quietly secured millions in loans in Pounds, which he then converted to dollars. Once his money was securely in dollars, he went from quiet to noisy. He publicly voiced his opinion that the pound was seriously overvalued, and that he considered its devaluation to be imminent. Many others followed suit, and a run on the Pound was the result. The UK tried, unsuccessfully, to prop up the Pound, but after only three days, the UK was forced to withdraw from the ERM and float its currency, which settled at around 85% of its initial value.

Soros was then free to convert his money back into pounds at this new exchange rate, pocketing nearly $950 million in the process.

So, what is the downside? Well, in this case, the UK arguably came out on top, since their interest rates returned to normal, and unemployment subsequently tanked – the devaluation, although provoked by Soros, was considered by many to be inevitable and desirable. However many, including Paul Krugman, argue that such hedge funds and speculation against the value of a currency contribute greatly to crises in emerging markets, including the recent economic collapses in Asia. The argument is that by speculating against the currency in the time of a minor economic downturn, it greatly inflates the size of the crisis, because the size of the economies that speculate on these currencies dwarf the emerging economies themselves.

Some accuse Soros of being a hypocrite in this respect, because his philanthropic efforts are, by and large, poised to change the rules of the game that he has played so well. He is very quick to condemn the system he has exploited, but feels he is simply “playing by the rules”.

For more information about this and more, Krugman’s book, The Return of Depression Economics, (which I have reviewed here) is a great reference, and a great introduction to international economics. Soros himself has also written a number of books, including The Crisis of Global Capitalism, Open Society: Reforming Global Capitalism, and George Soros on Globalization.