What it means
In the early 1990s, several European countries linked their currencies to one another through the Exchange Rate Mechanism, or ERM. Each currency was allowed to move only within a narrow band against the others.
The aim was to create stability ahead of a planned single currency. The pound entered the mechanism at a rate that many traders believed was too high for the British economy.
Interest rates were high to support the pound, even though the economy was weak. Currency traders could see the tension and began selling sterling in large amounts, betting that the government could not hold the line.
On the day itself, the Bank of England bought pounds with its reserves and the government announced sharp interest rate rises in an effort to attract buyers. The selling continued and, by the evening, the UK suspended its membership of the mechanism.
The pound was then free to fall. The aftermath was mixed.
Sterling weakened, which helped exporters, and the government could cut interest rates to support the economy. The event damaged the reputation of the government of the day, and it showed that even large countries cannot always resist determined market pressure when the fundamentals do not support the exchange rate.
For finance professionals, the story illustrates currency risk, speculative attack and the cost of fixed exchange rate regimes. A company with foreign-currency payments saw the cost of imports rise overnight, while exporters gained.
It remains a standard case in treasury and economics courses. The event also changed how policymakers think about commitments.
Later governments gave more weight to credibility and to letting markets set the exchange rate, and the Bank of England was eventually given independence over interest rates. Those changes grew partly out of the lessons of that day.
In practice
Real-world examples.
Example
A UK furniture importer has unhedged dollar invoices due in 60 days. When sterling drops, its cost of goods rises sharply. The finance director begins hedging with forward contracts so that future costs are fixed in advance. The board approves a policy that sets the minimum share of payments to be hedged.
Example
A British engineering exporter prices its machines in sterling. After the pound falls, the machines become cheaper for foreign buyers and orders rise. The company's sales grow by 12% in the next year without any change in sterling prices.
Example
A currency strategist at a bank explains to clients how central banks hold reserves to defend an exchange rate. She shows that reserves are finite, while the volume of currency traded each day can be vast. Clients use the case to decide how much exchange rate risk to accept. Several of them ask their treasury teams to test the effect of a 15% move in the main currencies.
Formula
Calculation
Cost in home currency = Foreign currency amount / Exchange rate (foreign currency per 1 unit of home currency)
A UK importer owes a supplier $900,000. At an exchange rate of 1.80 dollars per pound, the cost = 900,000 / 1.80 = GBP 500,000. If sterling falls to 1.50 dollars per pound, the cost = 900,000 / 1.50 = GBP 600,000. The importer pays GBP 100,000 more, which is 20% higher, for exactly the same goods.Case study
Seen in the real world.
Brackenridge Imports is a fictional company that bought machine parts from a foreign supplier priced in a stronger currency. Its owner assumed the home currency would stay stable because the government had promised to defend it. He left a large amount of future payments unhedged.
When the currency was forced to devalue in this illustrative scenario, the cost of the next shipment jumped by 18%, wiping out the quarter's profit. After the shock, the company adopted a treasury policy that required hedging at least 70% of foreign-currency payments over the next six months. The owner learned that a government promise is not the same as a hedge.
The company also began to review its supplier contracts, adding clauses that shared exchange rate movements above a set band. Over the next two years its profit became far less sensitive to currency swings.
Watch out
Common mistakes.
- Assuming a government can always defend its currency. Reserves are limited and markets can be larger.
- Leaving foreign-currency payments unhedged because a rate looks stable. Pegged rates can break suddenly.
- Thinking a weak currency is bad for everyone. Exporters usually benefit while importers pay more.
Questions
People also ask.
What was the Exchange Rate Mechanism?
It was a system in which European currencies were kept within agreed bands against each other before the euro was introduced.
Why is it called Black Wednesday?
The day is considered black because of the heavy losses to the government and the public purse, although some people later regarded the exit as beneficial.
What can companies learn from it?
Companies should measure currency exposure, hedge a sensible share of it and avoid relying on official promises to protect them.
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