An example of a mispriced currency

Many people may still remember the Black Wednesday on September 12th, 1992 when the British government was forced by the market to withdraw its currency from the European Exchange Rate Mechanism. Some people may blame or admire George Soros's strategy and the event eventually caused a cost of estimated 3.3 billion pounds to the British public, which shows how important precisely valuing a currency is. Moreover, from this example, we could also find out an important cause of mispricing a currency.

The British government attached its pound sterling to the European Exchange Rate Mechanism, meaning the pound sterling would have a relatively fixed exchange rate with the German currency at the time. The British central bank had to conduct monetary policies to prevent the exchange rate of the pound sterling with other member currencies from fluctuating over 6%. However, the British central bank failed to keep the inflation rate as low as the German inflation rate; therefore, years after years, the accumulated inflation in Britain was much greater than the inflation in Germany, as the exchange rate of the pound sterling and the German currency stayed relatively stable, the pound sterling was actually overpriced because the greater inflation devalued the pound sterling. The speculators observed this mispricing and forced the British government to withdraw the pound sterling from the European Exchange Rate Mechanism and gained enormous profits.

The key issue here is the countries agree to have a fixed exchange between their currencies, but ignore the differences in their economies, especially the inflation. Once they agree on a fixed nominal exchange rate but have different inflation rates, their currencies could be mispriced according to the inflationary factor.

This example tells once when we test currencies with fixed exchange rates with other currencies, for example, when testing HKD, it is important to compare the countries' inflation rates, as different inflation rates could easily lead to mispricing.