Bill Lipschutz: The Sultan of Currencies

(continued)

In exchange-traded markets, do you believe that stops have a tendency to get picked off?

As you know, I do very little trading on exchanges with trading pits. The vast majority of my trades are done either in the interbank market or on the Philadelphia Exchange, which uses a specialist system. However, in answer to your question, I can tell you a story about a fellow who was at Salomon in the late 1980s. He had been trading a market that had gone into a narrow range, and trading activity had dried up. During this period, a lot of stops had built up right above this trading range. One day, this trader's clerk on the floor calls and says, "Listen, the talk is that tomorrow (a day on which the liquidity was expected to be substantially below normal because of a holiday affecting the cash market) they're going to gun for the stops above the market." At that point, the stops were relatively close-about 40 or 50 ticks higher.

The next day, this trader's plan is to sell the market heavily once the stops are hit, because he believes such a rally would be artificial and that the market would be vulnerable to a subsequent sell-off. During the morning, the market trades sideways and nothing happens. Then around 1 P.M., prices start to move-down.

You did say that the stops were above the market?

That's right. Anyway, the market moves down 50 points, 100 points, and within a few minutes the market is down over 200 points. What happened was that the floor traders went for the stops below the market, which were 200 points away, instead of the stops above the market, which were only 50 points away. The reason was that everybody was ready for the rally to take out the stops on the upside. Therefore, everyone was long, and the direction of greatest price vulnerability was on the downside.

During the sharp break, my friend realizes that the market is way overextended on the downside. He screams at his clerks, "Buy 'em! Buy any amount they'll sell you. Just buy 'em!" He was bidding for hundreds of contracts between 100 and 200 points lower, and he was only filled on fifty, even though the market traded down over 200 points, with a couple thousand lots trading at those levels.

What happened to his bid?

You've obviously never traded on the floor of an exchange. In a trading pit, it's possible for the market to trade at several different prices at the same moment during periods of rapid movement. They were looking right past my friend's floor brokers, who were bidding higher. It was a fast market. (When an exchange designates "fast market" conditions, floor brokers can't be held for failing to fill orders that were within the day's traded price range.) A fast market gives the floor brokers a special license to steal, above and beyond their normal license to steal.

I'm not making any allegations, because I can't prove that any of this happens. It's just my opinion that situations like this sometimes occur in some open outcry markets.

Dinner is over, and we return to the living room for a continuation of the interview "on the record."

Do you remember your first major trade and the thinking behind it?

The trade involved a bond issue that allowed for redemption in either sterling (another name for British pounds) or U.S. dollars. The issue was grossly underpriced-the problem was that it was mispriced by Salomon Brothers, one of the lead underwriters. When I first heard the details, I couldn't believe how mispriced it was. I actually wanted to buy the whole issue.

What was the essence of the mispricing?

At the time, U.K. interest rates were a lot lower than U.S. rates. Consequently, forward sterling was trading at a huge premium to the spot rate. (If two countries have different interest rates, forward months of the currency with lower rates will invariably trade at a premium to the spot currency rate. If such a premium did not exist, it would be possible to borrow funds in the country with lower rates, convert and invest the proceeds in the country with higher rates, and buy forward currency positions in the currency with lower interest rates to hedge against the currency risk. The participation of interest rate arbitrageurs assures that the forward premiums for the currency with lower interest rates will be exactly large enough to offset the interest rate differential between the two countries.)

The way the bond issue was priced, the sterling redemption option essentially assumed no premium over the spot rate, despite the huge premium for the currency in the forward market. Therefore, you could buy the bond and sell the sterling forward at a huge premium, which over the life of the bond would converge to the spot rate.

What was the term of the bond?

The bond matured in four tranches: five, seven, nine, and twelve years.

I don't understand. Is it possible to hedge a currency that far forward?

Of course it is. Even if you can't do the hedge in the forward market, you can create the position through an interest rate swap. However, in the case of sterling/dollar, which has a very liquid term forward market, there was certainly a market for at least ten years out.

How big was the issue?

There were two tranches: the first for $100 million and the second for $50 million.

What happened when you pointed out that the issue was grossly mispriced?

The initial response was that I must be wrong somehow. They spent nine hours that day running it past every quant jock in the house until they were convinced I was right.

Did they let you buy the issue?

Yes, but by the time I got the approval, $50 million of the first tranche had already been sold. For the next year or two, I tried to acquire the rest of the issue in the secondary market. I always had a bid in for those bonds. Largely with the help of one salesperson who knew where the original issue was placed, over the next two years, I was able to acquire $135 million of the total outstanding issue of $150 million.

Once I bought the issue, I immediately sold an equivalent of 50 percent of the total amount in the forward sterling market. Remember that the forward pound was at a large premium. For example, the spot rate (and the rate at which the bonds were redeemable in sterling) was $1.3470, while seven-year forward sterling was trading at approximately $1.47 and twelve-year forward sterling at approximately $1.60. (The sale of half the total amount in the forward market effectively converted half the position into a proxy put on the British pound, while the original issue was, in effect, a call position. Thus, half the position was a call and half a put, the key point being that the put was established at a much higher price than the call. This gap essentially represented a locked-in profit, with the potential for an even greater profit if the forward pound moved below $1.3470 or above, say, $1.47 in the case of the seven-year tranche.)

Anyway, what ultimately happened is that U.K. interest rates eventually reversed from below to above U.S. rates, thereby causing the British pound forward rates to invert from a premium to a discount to the spot rate. I covered the whole position at a huge profit.

Are there any other trades in your career that stand out as particularly memorable?

One that comes to mind occurred at the time of the G-7 meeting in September 1985, which involved major structural changes that set the tone in the currency markets for the next five years. (This was the meeting at which the major industrialized nations agreed to a coordinated policy aimed at lowering the value of the dollar.)

You were obviously very closely tied into the currency markets. Did you have any idea that such a major policy change was at hand?

No. There were some people who had an inkling that there was going to be a meeting at which the Western governments were going to drive the dollar down, but nobody understood the magnitude of what that meant. Even after the results of the meeting were reported, the dollar traded down, but nothing compared to the decline that occurred in the ensuing months. In fact, after an initial sell-off in New Zealand and Australia, the dollar actually rebounded modestly in Tokyo.

How do you explain that?

People didn't really understand what was happening. The general attitude was: "Oh, another central bank intervention." Remember that this meeting took place after years of ineffective central bank intervention.

What was different this time?

This was the first time that we saw a coordinated policy statement from the seven industrialized nations. Anyway, I was out of the country at the time of the G-7 meeting. I don't take vacations very often, but I had had a very good year, and I was in Sardinia at the time. Sardinia is fairly isolated, and it takes something like two hours to make an overseas call.

Were you aware of the situation?

I didn't even know what the G-7 was. The meeting didn't have any significant implication at the time; it was just a bunch of bureaucrats getting together to talk down the value of the dollar.

There was never any G-7 meeting before that time that had any significant impact on the dollar?

Absolutely not. Anyway, I'm lying on the beach, totally oblivious to the ongoing bedlam in the world currency markets. For whatever reason- probably because it was close to the end of my vacation and I was starting to think about getting back into the markets-I decided to call my office early Monday morning, New York time, and check whether everything was running smoothly in my absence. With great difficulty, I finally got a line through to New York, but there was no answer in my office. The failure to get an answer was very unusual because my assistant, Andy (Andrew Krieger), always came in very early. I was a little concerned. I then called our London office to check on the currency markets.

"Dennis, what's going on in the currency market?" I asked.

"You know about the G-7 meeting, of course, don't you?" he asked.

"No," I answered. "What are you talking about?"

"Well, they've come up with this manifesto to bring down the value of the dollar, and the dollar is going to hell."

"Do you know where Andy is?" I asked.

"Oh, Andy is out sick today," he answered.

This was odd, because neither one of us was ever out sick. After a great deal of effort, I finally got through to Andy at home. He was in bed with the flu and running a high fever.

Did you have any position going into the G-7 meeting?

Yes, we had a small short dollar position, but nothing significant.

Did Andy have the authority to trade?

Yes, of course. He was not only monitoring my positions but was responsible for trading rather significant ones himself. The interesting thing was that as soon as Andy read the news, he went into the New Zealand market, which is the first of the world's currency markets to trade after the weekend. Not many people traded in that time zone, and it was a very thin market. I think he was only able to get price quotes at all because we (Salomon Brothers) frequently traded $20 million to $50 million on Monday mornings in New Zealand. Therefore, it was not abnormal for Andy or myself to call. We had established relationships in that trading center when very few others-New Yorkers or Europeans-had.

On very wide price quotes-literally two big figures wide because everyone was confused-he sold $60 million in New Zealand, which was a tremendous amount back then.

(At this point, Bill re-created Andy's conversation with the New Zealand Bank:)

"What's your price for twenty (million) dollars?"

"Two eighty bid, two eighty-two offered."

"Sold. How do you remain?"

"Two seventy-nine, two eighty-one."

"Yours twenty. How do you remain?"

"Two seventy-eight, two eighty."

"Yours twenty."

Andy was hitting bids six big figures below Friday's close. I was really impressed that he had that type of insight. I wouldn't have done that.

To make a long story short, for six hours I had an open line from my hotel room in Sardinia to Andy, who was out sick, flat on his back, in Englewood, New Jersey. It was so difficult getting an overseas phone connection that we just left the line open all day. Andy had the line to me and an open line to the floor on the Philadelphia Stock Exchange, where we were trading currency options. In addition, he had his wife run out to Radio Shack as soon as they opened to purchase one of those extra-long telephone cord extensions. He then brought in a third line from the neighbor's house to allow him to establish an open phone to our spot dollar/mark broker so that we could trade the cash market. We traded that way for six hours. We made $6 million that day, which at that time was probably more than 25 percent of our total annual profits.

We were staying at this luxurious resort that was largely frequented by wealthy Europeans. One humorous sidelight was that, while all that was going on, these two industrial magnate types-older German men, impeccably groomed, with perfect tans and accompanied by women who were obviously their daughters-kept coming by my room every ten minutes to ask in German what was happening. My wife did the translating. They knew that something important was going on in the foreign exchange market, but no one knew anything specific. Sardinia is so isolated that all the available newspapers are at least two days old. But I was right there.

• < previous
• next >