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Let's begin with a legendary trader, the Fortune's favourite.
If you ask Google, "Who is the greatest Forex trader?", the name of Soros would figure on the top of the list. One of the greatest investors in history, a trader, who broke the Bank of England, he's reportedly made his fortune winning more than £1,5 BLN on short position on Black Wednesday (16 September 1992). Isn't it the example of great insight and courage?
It stands to mention, that at the time, Great Britain was a part of the Exchange Rate Mechanism (ERM). ERM activated government intervention in case the pound weakened against the Deutsche Mark by a certain level. That time the Deutsche Mark was the main currency in Europe since Germany had the most stable economy.
As it was mentioned above, Britain had committed to maintaining the pound's value, which was already sliding down. The government could support the pound value in two ways. The first included spending the gold reserves for buying the pound. In other words, Britain could intervene to keep the currency in line with the currencies of other countries. The other one intended raising the interest rates. Actually, the government could choose to do both at the same time. However, all the methods would hurt the economy badly. Spending the reserves meant wasting the taxpayer's money, and raising the interest rates would demotivate already poor investing.
It was George Soros who managed to predict the peak of the vulnerability of the Bank of England and fire point-blank.
How did he do that? Soros had been building a large pound position during a few months preceding the Black Wednesday, waiting for a trigger to go short.
On the Black Wednesday's Eve, Soros had received the statement made by the President of the Bundesbank, reporting one or two European currencies might become suppressed quite soon. Soros had banked on the pound and came up trumps. With the help of the hedge fund and partners, Soros had accumulated a large amount of pound to sell. He also was brave enough to borrow billions of pounds to expand his hedge fund to 15 billion pounds.
The headings of major British newspapers in September 1992. Illustrates the negative public reaction to governments' actions.
Borrowing so much money is very risky, you would say, and rightly so. But for Soros and his partners that was a great opportunity to beat the spread, risking at the worst only the loan interest, whereas the scale of possible profit was just enormous. Imagine what would happen, if you did the same:
- Let's say, you want to go short with pounds. You take a £100 loan with some interest. You convert these pounds into 200 units of other currency, hoping the pound to drop in value relative to the currency you have.
- Why do you hope for that? Because if the pound drop in 20%, you will receive 220 units of the currency you've bought, if you decide to change the pound back. After you can pay the loan back, pay the interest and you still would have about 15-19 currency units of profit.
Now imagine the effect of such strategy, if we speak about shorting 15 billion pounds? By 9 a.m. on Black Wednesday the British government could do nothing to hold the extreme slide of the currency price. Even though they increased the interest rates from 10% to 12% and bought as many pounds as they could afford, none of that helped. By the next day, the pound cost 15% less relative to the Deutsche Mark and 25% less relative to the U.S. dollar.
After the devaluation of the pound, the Soros' hedge fund value increased up to 22 billion pounds. Since the hedge fund managers usually earn 20% of the profit, Soros and his partners got about 1.5 billion pounds each on this deal.