The European Exchange Rate Mechanism (ERM) was introduced to reduce exchange rate variability and achieve monetary stability in Europe. It was part of the European Monetary System (EMS) and aimed to prepare European countries for the adoption of a single currency, the euro.
How ERM Works:
-> Central Rate: Each participating country's currency had a central exchange rate against the European Currency Unit (ECU), which was a weighted average of the participating currencies.
-> Fluctuation Bands: Currencies were allowed to fluctuate within a set margin around the central rate. Initially, this margin was ±2.25%, but some currencies had wider bands.
-> Intervention: Central banks intervened in the forex market to maintain their currency within the agreed bands by buying or selling their currency.
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Example:
Let's consider the British pound (GBP) in the ERM:
Central Rate: Suppose the central rate was set at 1 ECU = 0.70 GBP.
Fluctuation Band: With a ±2.25% band, the GBP could fluctuate between 0.68425 and 0.71575 per ECU.
Intervention: If the GBP approached the upper limit (0.71575), the Bank of England would sell GBP and buy foreign currencies to bring it back within the band.
(GBP reaches the upper limit because the demand is high so the Bank of England sells GBP to fulfill the demand and stabilize the fluctuation. In the finance field the most basic thing you have to understand to the concept of Demand & Supply because they will decide the value.)
(For example, the demand for Gold is high but supply is less so the gold price is high but if the market is flooded with gold then it will fall.)
Real-World Example=> Of ERM
George Soros is famously known for his role in the 1992 currency crisis, often referred to as "Black Wednesday."
(To summarize => he short the British Pound and made 1 Billion dollar)
(By now you should already know what short and long mean as I'm trying to explain all the financial concept as they come)
Here's a summary of how he managed to "break the Bank of England":
Background: In 1990, the UK joined the European Exchange Rate Mechanism (ERM), which aimed to stabilize exchange rates by tying them to the German mark. However, the UK economy was weaker compared to Germany's, leading to high interest rates and economic strain.
Soros' Strategy: Soros believed that the pound was overvalued and that the UK would eventually have to devalue it or withdraw from the ERM. He began shorting the pound, which means he borrowed pounds and sold them, planning to buy them back at a lower price later.
Market Pressure: On September 15, 1992, Soros and other speculators aggressively sold pounds, causing its value to plummet. The Bank of England tried to defend the currency by buying pounds and raising interest rates, but these measures failed to stabilize the currency.
Outcome: On September 16, 1992, the UK government withdrew the pound from the ERM and devalued it. This led to a significant drop in the pound's value, and Soros made an estimated $1 billion profit from his short positions.