two plates.According to the U.S. Geological Service, the megathrust earthquake lifted thesea floor by several meters. Subsequent estimates of the magnitude of the quakerange from 9.0 to 9.3.
2
The earthquake is also called the Great Hanshin, South Hyogo, and the Hyogoken Nanbu earthquake. The Kobe earthquake is sometimes referred to as havingmagnitude 6.9 and sometimes referred to as having magnitude 7.2. The latternumber is the Japan Meteorological Agency assigned magnitude, whereas theformer number is the moment magnitude. (The former commonly used measure of the force of an earthquake, the Richter scale, is no longer used.)
3
Damages from earthquakes can be categorized into direct and secondary effects.Direct effects refer to the damages resulting from the rupture of the earth nearor alongside the fault line (e.g., a landslide), whereas secondary effects refer todamages induced from the seismic waves coming from the earthquake. As withmost earthquakes, the principal damage comes from the secondary effects (seismic waves) rather than the direct effects. The economic damage of an earthquake depends not only on the destructive power of an earthquake andproximity to the epicenter but also on how people live. Earthquake-resistantbuildings help to minimize the death toll associated with earthquakes. Most ofthe buildings that were destroyed in Kobe were built before 1981 under weakerbuilding codes.
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4
Perhaps the most famous casualty of the Kobe earthquake was Barings Bank.The trading positions that rogue trader Nick Leeson had built up started tounravel after the Kobe earthquake.
5
Andi Spicer. “Commodities-Metals: Kobe Earthquake Disaster Boosts MarketDemand.” Inter Press Service, January 20, 1995.
6
Kevin Rafferty and Mark Milner. “European Markets in Spin from Fall-Out ofKobe Earthquake.” The Guardian, January 24, 1995.
7
Kevin Rafferty and Mark Milner. “European Markets in Spin from Fall-Out ofKobe Earthquake.” The Guardian, January 24, 1995.
8
Information obtained from the United States Geological Service, EarthquakeHazards Program Web site: http://earthquake.usgs.gov/.
9
The most powerful recorded earthquake of the twentieth century was a magnitude 9.5 earthquake in Chile on May 22, 1960 that killed 4,000 to 5,000 people.This is followed by a magnitude 9.2 earthquake in Prince William Sound inAlaska in 1964 and a magnitude 9.1 earthquake that occurred in Alaska in 1957.
10
Robert Shiller. “Exuberant Reporting: Media and Misinformation in the Markets.” Media, Vol. 23, (1) Spring 2001.
11
Because estimated death tolls from earthquakes often vary considerably fromsource to source, this book uses estimated death tolls reported by the UnitedStates Geological Service, Earthquake Hazards Program Web site.
12
There is some evidence that a rare human disease, variant Creutzfeldt-Jakob, iscontracted from consuming beef from cattle infected with mad cow disease.
13
Paul Haavardsrud and Peter Morton. “Fast-Food Stocks Plummet: McDonald’sShares Down 8%; U.S. Temporarily Bans Import of Canadian Cattle, Sheep andGoats.” National Post, May 21, 2003.
14
Yiuman Tse and James Hackard. “Holy Mad Cow! Facts or (Mis)perceptions: AClinical Study.” Journal of Futures Markets, Vol. 26, No. 4, April 2006, pp.315-341.
15
Yiuman Tse and James Hackard. “Holy Mad Cow! Facts or (Mis)perceptions: AClinical Study.” Journal of Futures Markets, Vol. 26, No. 4, April 2006, pp.315-341.
16
Yiuman Tse and James Hackard. “Holy Mad Cow! Facts or (Mis)perceptions: AClinical Study.” Journal of Futures Markets, Vol. 26, No. 4, April 2006, pp.315-341.
17
Yiuman Tse and James Hackard. “Holy Mad Cow! Facts or (Mis)perceptions: AClinical Study.” Journal of Futures Markets, Vol. 26, No. 4, April 2006, pp.315-341.
18
Agence France Press. “HK Shares Lower on Concerns Over Iraq War, SARS.”March 31, 1995.
19
Dow Jones Newswires. “1-Yr HK$ Forward Premium To Spot Hits 5-Mo Highon SARS.” April 21, 2003.
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20
Dow Jones Newswires. “HK Dlr Mkts Late: HK Dlr Forwards Continue toSurge on SARS.” April 25, 2003.
21
Andrew Torchia. “Asian Markets Decline on Fears about SARS—Stock Prices,Currencies and Interest Rates Drop.” The Asian Wall Street Journal, April 28,2003, p. M2.
22
Andrew Torchia. “Asian Markets Decline on Fears about SARS—Stock Prices,Currencies and Interest Rates Drop.” The Asian Wall Street Journal, April 28,2003, p. M2. The article notes: “Bonds were bought … as investors bet thatSARS would force central banks to keep interest rates very low….”
23
United States Geological Service Web site: http://md.water.usgs.gov/drought/define.html.
24
Masood Farivar. “Oil Prices Surge as Tropical Storm Approaches Gulf.” TheWall Street Journal, June 10, 2005, p. C4.
25
The Wall Street Journal. June 10, 2005, p. B6.
26
Andrew Bary. “Trading Points.” Barron’s, August 31, 1992, p. 39.
27
The earthquake is popularly known as the San Francisco earthquake, eventhough it covered a distance of more than 430 kilometers. The United StatesGeological Service estimates the loss of life at around 3,000 people. Informationabout the quake can be found at http://72.14.207.104/search?q=cache:X_S4pAl02IcJ:quake.wr.usgs.gov/info/1906/+san+francisco+earthquake+of+1906&hl=en.
28
John Dennis Brown. 101 Years on Wall Street: An Investor’s Almanac. Englewood Cliffs, New Jersey: Prentice Hall, 1991, p. 33.
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6MARKETINTERVENTIONS
“The causes of events are ever more interesting than theevents themselves.”—Cicero
A Tale of Two Market InterventionsOn Friday, September 22, 2000, traders witnessed two major marketinterventions. One was intended to increase the foreign exchangevalue of the euro. The other was intended to decrease the price of oil.One was the result of collective action by a group of central banks.The other was a unilateral action by the U.S. government. One intervention came as a surprise to market participants. The other intervention was widely anticipated before it was announced. Both the actualintervention in the currency market and the anticipated intervention163
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in the oil market impacted prices and volatility significantly. Yet,judged from a longer-term perspective, only one intervention wasultimately successful.
Central Banks Defend the EuroAround 12:15 P.M. London time on Friday, September 22, 2000, theEuropean Central Bank (ECB) together with the Federal Reserve,the Bank of Canada, and the Bank of Japan suddenly bought billionsof euros in a coordinated move intended to drive up the foreignexchange value of the euro.1 This was followed by two additionalrounds of euro purchases by the central banks. The coordinated intervention by the group of central banks took the foreign exchange (FX)market by surprise. The effect was immediate and dramatic. The euroquickly rose by over two cents against the U.S. dollar and triggered arally on some European stock markets.2 However, the effect of theintervention on the value of the euro was also short-lived.The market impact of the coordinated intervention is depicted inFigure 6.1 and captured in the following excerpt from an article thatappeared in The Times on Saturday, September 23, 2000.…Although the single currency leapt close to 90 cents against thedollar soon after banks began buying euros just after midday, it laterfell back to around 88 cents—only modestly above its value beforethe intervention began, but still well above the record low of 84.43cents hit on Wednesday…Yesterday’s action caught markets on the back foot in the wake ofpersistent speculation that the US was unwilling to take part in acoordinated rescue attempt…The banks are already estimated tohave spent between $6 billion (£4.1billion) and $8 billion in threerounds of intervention yesterday, with the European Central Bankspending as much as $4 billion.3
0.96509/22/00date.open 0.8603date.high 0.9036date.low 0.8573date.close 0.8769
0.95509/22/00Central bankintervention
0.94500.93500.92500.91500.90500.89500.88500.8750
CHAPTER 6 • MARKET INTERVENTIONS
0.9750
0.86500.85500.84500.83500.82507/3/00
8/3/00
9/3/00
10/3/00
11/3/00
12/3/00
Reaction of the euro/dollar exchange rate to central bank intervention on September 22, 2000. Daily trading range of the euro/dollarexchange rate from July 1, 2000 to December 31, 2000.
FIGURE 6.1
Central banks defend the euro.
165
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TRADING CATALYSTS
The decision to intervene jointly to defend the euro was driven bypersistent weakness in the euro and fears of what a weak euro mightmean for economic growth. The euro, the common currency unit formost European Community member states, had basically been in asteady downtrend since its introduction on January 1, 1999. Illadvised comments by Wim Duisenberg, president of the EuropeanCentral Bank, and other officials from various European governments since its introduction buffeted the currency and exacerbatedits decline. By Wednesday, September 20, 2000, the euro had fallenalmost 28% below its initial exchange rate of € = $1.17. The prospectof further declines in the euro prompted the central banks to collectively intervene to halt the slide.Some observers attributed much of the power of the coordinatedcentral bank intervention to the fact that the Federal Reserveparticipated in it.4 The participation of the U.S. Federal Reserve wassurprising because the Clinton Administration was openly pursuing astrong dollar policy at the time. It was also surprising because theU.S. was in the midst of a presidential election campaign. Indeed,some market observers argued that concern that the Federal Reservewould not participate in a joint intervention to support the euro during the U.S. presidential campaign led to sharp declines in the europrior to the joint intervention. Put differently, many traders believedthat it was safe to bet against the euro because the U.S. would notintervene in the FX markets to support the euro and previous ECBinterventions had proven largely ineffective.Contemporary news accounts indicated that the central bankswould be happy if the euro stayed above 87 U.S. cents.5 The questionnaturally arises as to whether the coordinated central bank action wassuccessful. The answer depends upon the time frame one uses toevaluate the market impact. In the very short-run, the answer is yes.However, over a marginally longer period of time, such as a day, theanswer is no. As the excerpt notes, there was an immediate upward
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boost in the value of the euro following the successive rounds ofintervention that largely disappeared by the end of the trading day.The euro resumed its downward slide against the U.S. dollar in subsequent trading days and reached an all-time low against the dollar of$0.823 on October 26, 2000—significantly below the desired minimum of $0.87.The Bank for International Settlements estimates that over $1.9trillion of foreign currency trades every business day, based on resultsfrom an April 2004 survey.6 Most of the trading volume is concentrated in a handful of currencies. Even the largest central banks typically do only a small fraction of that total in a currency marketintervention. In this case, the excerpt notes that the ECB spent $4billion trying to prop up the euro that day and the other central banksspent an additional $2 to $4 billion.This raises a more fundamental question: Namely, why shouldcentral bank intervention to support a currency be successful at allgiven the large size of the foreign exchange market? The answer isthat central bank interventions create short-term risks for market participants. To increase their impact, central banks often concentratetheir interventions during market periods where liquidity is low andtrading volume is low, such as around holidays or weekends. Academic studies have shown that trading volume follows a U-shaped pattern in many markets with significantly greater volume at the openand close of trading. Sometimes, the central bank or central bankscan magnify the impact of a market intervention by triggering a pricemove that causes traders to cover their losing positions. This reinforces the central bank’s actions and exacerbates the move in prices.Enlisting the support of key central banks can also have an impact asshown in the opening example with the participation of the FederalReserve. The midday London time of the intervention allowed thecentral banks to influence trading in both London and New York—two of the three principal centers of foreign exchange trading.
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Tapping the Strategic Petroleum ReserveIn the late afternoon (Washington, D.C. time) on the same Friday, theClinton Administration announced a swap of 30 million barrels of oilfrom the Strategic Petroleum Reserve (SPR). The objective was todrive the price of crude oil down by flooding the oil market with “new”supply. The hope was that the action would trigger a decline in crudeoil prices and a decrease in the price of heating oil and other keypetroleum derivative products. Although the move was announcedafter the market closed, speculation that the administration wouldannounce a swap drove crude oil futures prices down 4% earlier in theday. The price action is captured in the following excerpt, from an article by Katherine Spector, that appeared in The Oil Daily on September 25, 2000.Talk that the Clinton administration was preparing to releaseUS strategic reserves onto the market…sent the crude complex down further Friday after a week of volatility. Novemberlight, sweet crude on the New York Mercantile Exchange(Nymex) plunged $1.32, settling at $32.68/barrel.Trade was somewhat tumultuous throughout the week, withthe October contract reaching as high as $37.80 Wednesdaybefore expiring at $37.20. But where the October contractwent out with a bang, November came in with a fizzle, losing$1.24 on Thursday, its first day as the front-month contract.Friday’s decline leaves November crude $2.56 below its$35.24/bbl debut…Products tumbled with crude, with October heating oil losing4.41¢ to settle at 95.48¢/gallon, down a stunning 7.81¢ for theweek.7The Clinton Administration’s decision was driven by rising crudeoil and heating oil prices. Crude oil prices reached a 10-year high inthe fall of 2000. Adding to the pressure on crude oil prices was a flareup in tensions between Iraq and Kuwait. On Monday, September 18,2000, New York Mercantile Exchange West Texas Intermediate
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crude oil futures closed almost a dollar higher on renewed tensionsbetween Iraq and Kuwait.8Basically, Iraq accused Kuwait of stealing 350,000 barrels of oil aday from Iraqi fields bordering Kuwait. Iraq had a powerful weaponin its arsenal of threats to achieve its objectives. Iraq’s weapon was notmilitary but economic—the threatened withdrawal of its 2.3 millionbarrels per day oil production from the export market during a timewhen other Organization of Oil Exporting Countries could not makeup the slack.On Thursday, September 21, 2000, U.S. Vice President (andDemocratic presidential candidate) Al Gore reacted to higher crudeoil prices by proposing a program where oil from the SPR would belent to, or swapped, with private oil companies. Under his plan, theoil would be swapped at rates determined in a series of five or six auctions of five million barrels each. The borrowed oil would be repaidwith interest (i.e., additional oil) at a future date when the price of oilwas presumably cheaper. At the time, the U.S. government had anestimated 570 million barrels of crude oil in the SPR.9The Gore campaign released the vice president’s proposal to tapthe SPR to the news media in the early morning of Thursday, September 21, 2000 before a scheduled campaign event later in the day (andbefore trading in oil futures opened on the NYMEX).10 Not surprisingly, the oil futures market sold off on uncertainty over whetherGore’s proposal would be implemented by the Clinton Administration. Coming in the midst of the 2000 presidential election campaign,the decision was also, not surprisingly, criticized as a calculated political move by the Republican presidential candidate Texas GovernorGeorge W. Bush and some market observers. The oil futures marketsold off even more on Friday as it became apparent that the Gore proposal would be implemented. The reaction to the anticipated ClintonAdministration decision to tap the SPR is depicted in Figure 6.2.
170
38.00
36.00
34.00
32.00
30.00
9/22/00Clinton taps the Strategic PetroleumReserve
9/22/00date.open 33.71date.high 34.40date.low 32.50date.close 32.68
28.00
26.00
24.007/5/00
8/5/00
9/5/00
10/5/00
11/5/00
12/5/00
FIGURE 6.2
The U.S. taps the Strategic Petroleum Reserve.
TRADING CATALYSTS
Reaction of NYMEX front month crude oil futures prices to the Clinton Administration decision to tap the Strategic Petroleum Reserveon September 22, 2000. Daily trading range of NYMEX crude oil futures prices from July 1, 2000 to December 31, 2000.
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The market’s reaction to the Clinton Administration’s decision totap the SPR via an oil swap also illustrates how market prices may risedue to one trading catalyst—in this case, geopolitical factors in theMiddle East—and fall due to another trading catalyst—in this case,tapping the SPR—even though the factors that sparked the initialrally (e.g., tensions in the Middle East) remained. To be sure, theprice rally was due to the possibility of supply disruptions (i.e., Iraqrefusing to export crude oil) and the price break was due to the possibility of additional supply coming to market (i.e., from the SPR).However, the price impact on heating oil is not as easily explainedgiven the view at the time that heating oil production suffered notfrom a lack of oil but a lack of heating oil refinery capacity.11Recall that the official announcement of the oil swap came lateFriday afternoon after the oil futures market had closed in the U.S.However, the desired effect was achieved before then as speculationon the impending announcement had already pushed crude oilfutures prices down. This gave the Clinton Administration an opportunity to test the potential market reaction to the swap proposal byissuing it in the form of a trial balloon. The success of the oil swapstems, in part, from the fact that if the market had not reacted to itthe proposal would probably never have been implemented. The success also stems, in part, from the fact that the surprise potential fromtapping into the SPR was larger than it otherwise would have beenprecisely because many oil market participants believed that the Clinton Administration would not tap into the SPR during a presidentialelection campaign.
Market Interventions as Trading CatalystsMarket manipulation is illegal in most countries except when it isdone by the government or the central bank. However, the ability ofeven the wealthiest central bank or government to maintain a price
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different from the market price for an extended period of time islimited. Moreover, attempts to do so often consume substantialresources and usually result in wealth transfers from the public tospeculators. The inevitable adjustment to the market price is usuallysharp and quick. The economic dislocations that follow the adjustment can be substantial.Attempts by central banks or governments to maintain a nonmarket price or exchange rate create short-term risks for traders betting on a change. A sudden large move triggered by a central bank orgovernment intervention may be exacerbated by traders trying to cuttheir losses short. As noted in Chapter 3, “Talk Isn’t Cheap,” theattempts by governments and central banks to maintain a nonmarketprice or exchange rate also create one-sided bets. The bets are onesided in that the potential changes on either side of the current priceor exchange rate are not symmetric. Simply put, traders face smallerpotential downside losses than potential upside profits.For instance, consider an example where the exchange rate for acurrency has been artificially set above the market exchange rate. Ifthe central bank is able to maintain the artificially high exchange rate,the trader who shorted the currency faces the prospect of losses if thecurrency rises above the rate that the currency was sold at as well asany cost of carry. The cost of carry is simply the interest that wouldhave been earned had the funds been invested in a default-free security denominated in that same currency over the length of time thetrade is open. In many cases, the principal potential loss is the cost ofcarry. In a low interest rate environment, the cost of carry can be relatively low for small short-term trades. Alternatively, if the centralbank is unable to maintain the current artificially high exchange rateand the government devalues the currency, the trader faces theprospect of profits substantially in excess of the potential losses.Attempts by central banks to maintain a nonmarket exchange ratenot only create one-sided bets but also provide speculators the opportunity to do size (i.e., take a larger position) when taking the other
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side of the trade. This encourages speculative attacks on a currency incertain environments—that is, the central bank may be able to maintain the mispriced exchange rate in normal times but not in a crisisenvironment. The crisis may be set off by a trading catalyst. It isimportant to emphasize that speculative attacks need not be coordinated conspiracies but are often the logical outcome when confidence is lacking that the central bank will be able to maintain anonmarket exchange rate.The inclination to intervene in the foreign exchange market differs across nations. Compared with many other countries, the UnitedStates rarely intervenes to support its currency or assist in supportingother currencies (i.e., weaken the U.S. dollar). The basic philosophyis that free markets should determine exchange rates. The openingexample in this chapter is one exception. Another exception is discussed in the following excerpt from Marketplace, a financial newsradio program, that aired on June 17, 1998.…[T]he Federal Reserve Bank of New York began buying twomaybe three billion dollars worth of yen in an effort to prop upthe ailing Japanese currency. This was the first intervention inthe currency markets by U.S. central bankers since1995…and for today, at least, the effort worked with the dollarfalling about 6.5 yen during the course of the New York trading day. The stock market liked…the action…and the DowJones Industrial Average rose 164 points…[or] 1.9 percent.12The excerpt provides another demonstration of how a centralbank intervention can have a substantial short-term impact on marketprices—the dollar fell by 6.5 yen. It also illustrates how interventioninduced price changes in one market—the foreign exchange market—can impact price changes in another market—the stock market.In contrast, the Bank of Japan has frequently intervened to keepits currency within a desired range. Sometimes, this has involved selling yen and buying dollars. Other times, it has involved selling dollarsand buying yen. These interventions have often sparked large
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changes in the dollar/yen exchange rate.13 The Bank of Japan hasexpended enormous sums of money trying to maintain its desiredexchange rate. By one estimate, the Bank of Japan spent $182 billionduring 2003 and another $100 billion during January and February of2004 trying to maintain the yen within a desired trading range.14In many instances, devaluations are preceded by denials that theywill occur. This happened in Thailand shortly before the devaluationof the Thai baht on July 2, 1997, as noted in Chapter 3. It has happened elsewhere as well. For example, a sharp collapse in crude oilprices in the early 1980s put substantial downward pressure on theMexican peso. Mexican President Jose Lopez Portillo famouslypledged to “defend the peso like a dog” before abruptly devaluing thepeso by almost 42% in February 1982.15The common practice of politicians and policymakers denying apotential action before doing it extends beyond currency devaluations. There seems to be an implicit belief among many politiciansand policymakers that the market is fooled by denials of the obvious.It usually is not. For instance, although Russia devalued its currencyand defaulted on its debt on August 17, 1998, fears of a default hitfinancial markets days earlier as the following excerpt from an August11, 1998 Reuters news story suggests.Russian officials insisted on Tuesday that economic reformswould not be derailed despite a precipitous fall in financialmarkets…Prices for Russian government debt fell so low,traders said the market was pricing in a risk that either therouble would collapse or Russia would fail to repay its creditors on time.But Deputy Prime Minister Viktor Khristenko told a newsconference he saw no such risk. “The question of a Russiandefault has not even been posed,” he said…The Russian stock market has tumbled since last October onthe heels of Asian markets…The benchmark RTSI-Interfax
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share index ended down 9.11 percent at 109.90, a level notseen since May 1996, while yields on long-dated governmentdebt soared to around 130-140 percent from Monday’s closeat around 90-110 percent.16Just as denials by policymakers of prospective actions often lackcredibility in the marketplace, so do announcements that appear tobe an indirect implementation of some policy action that has beendenied. For instance, on August 12, 1998, a Russian governmentannouncement that it would carefully review purchases of foreignexchange nipped a nascent stock market rally in the bud and precipitated a 1.5% decline in stock prices when the announcement wasinterpreted by many traders as a precursor to making the roubleinconvertible. The announcement increased fears among traders of arouble devaluation and default on Russian government debt.17 OnAugust 13, 1998, the Russian equity and debt markets plunged.
Defending the IndefensibleA classic example of a one-sided bet occurred during the September1992 European monetary crisis when speculators accelerated theBank of England’s decision to withdraw from the European ExchangeRate Mechanism (ERM) and allow the pound sterling to adjust to anew lower exchange rate against the German mark. Some background information on the crisis is instructive.Before the euro was introduced in 1999, member nations of theEuropean Community experimented with a system of largely fixedexchange rates among the currencies of participating membernations. The objective of the European Monetary System was toreduce volatility in exchange rates among European Communitymember currencies. The principal feature of the European Monetary
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System was the ERM, in which currencies were pegged to the European Currency Unit, or ECU, (a unit of account) and allowed to fluctuate within a narrow band of 2.25% up or down.18 Governmentscould borrow funds from other central banks (most importantly, theDeutsche Bundesbank) to maintain the exchange rate within a narrow band. After some initial resistance, the British government joinedthe European Monetary System and ERM in 1990 when the poundsterling had a relatively high exchange rate to the German mark. Thepound sterling entered the ERM at an exchange rate of DM2.9. Thiswas an unsustainably high exchange rate. It was also an invitation fora speculative attack on the pound sterling at some point given theright trading catalyst.The creation of the European Union appeared certain when theTreaty of Maastricht was concluded. It required the approval of theparliaments of all 12 member nations of the European Community.The Danish and British governments requested permission to holdreferenda so that citizens of their respective countries could vote onwhether the proposed treaty should be ratified. On June 2, 1992, theDanish electorate narrowly rejected the Treaty of Maastricht. FrenchPresident François Mitterand decided that the French would alsohave an opportunity to vote on whether the treaty should be ratified,and a referendum was scheduled for Sunday, September 20, 1992.19The Danish rejection of the Treaty of Maastricht (discussed in Chapter 4, “Geopolitical Events”) was a geopolitical event that served as atrading catalyst that (along with uncertainty over whether French voters would approve the treaty) cast doubt on the prospects of a successful European Union and likely encouraged speculative attacks onthe currencies of various European Community members.A full-fledged currency crisis emerged by early September 1992.Central banks of affected countries responded by raising interest
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rates. The Bank of Sweden announced a target short-term interestrate of 500% in a vain attempt to slow selling of the Swedish krona