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Pound v dollar: How hedge funds benefit from a weaker sterling

Hedge funds have been accused of shorting the pound. Photo: Matt Cardy/Getty
Hedge funds have been accused of shorting the pound. Photo: Matt Cardy/Getty

The pound (GBPUSD=X) fell to its lowest level ever against the US dollar, and analysts now say it's headed for parity with the greenback — a sign that investors prefer keeping their money in America rather than Britain.

There have been some reports that hedge fund managers have been making huge profits over the past few days from shorting the currency as it plummeted following Kwasi Kwarteng's mini-budget.

Read more: Why has the pound fallen and what does this mean for you?

As the pound continues to thread uncharted waters, traders bet it will slide further, with a 43% chance of a GBP-USD parity by the end of the year.

So how do hedge funds make money from shorting the pound?

Why is the pound's fall significant?

Sterling sank to just $1.03 on Monday, before climbing back to $1.08 the day after.

On Wednesday it reversed some of its recovery after the International Monetary Fund and credit ratings agency Moody criticised the UK government's tax-cutting policies.

In a rare intervention of a G7 economy, the IMF — known as the world's lender of last resort — urged prime minister Liz Truss and Kwarteng to reconsider the top rate income tax cut as its likely to increase inequality.

The IMF said it was "closely monitoring" developments in the UK, and Moody's downgraded UK growth.

Sky News reported that the chancellor, who is due to meet with Wall Street chiefs later today, will ask bankers not to bet against the pound, however, the Treasury Department denied that he will be asking that.

That would be an extraordinary move from a government where both the PM and chancellor advocate free markets — an economic system based on supply and demand with little or no government control.

Read more: Pound run: BoE chief economist signals 'significant monetary response'

What is parity?

There has been a lot of talk about parity recently between the pound and the US dollar as analyst expect the British currency to fall further.

The term parity simply means the dollar and sterling being the same price.

At the moment it costs around $1.05 to buy £1, but if the currencies reach parity, this means $1 will be worth £1.

Parity with the US dollar is not the only struggle facing the pound, some experts think it is on a worse track against the euro (GBPEUR=X), reaching less than €1.

Watch: Pound hit again as IMF slams UK tax plans

What does short selling or shorting mean?

Shorting or short selling is a tool commonly used by investors in stock markets to make a profit in the difference of the value of a stock or security and the price they paid when buying it back.

Traders place bets against the stock or shares, or speculate on the falling price of a holding.

Typically the short seller borrows the asset from a broker and then sells the asset on at the current market price to buyers — keeping the proceeds of the price in difference.

It's also used in foreign exchange markets, or Forex (FX), where currencies are converted into other currencies.

Read more: Bank of England steps in to buy UK bonds to stem market turmoil

FX is traded in pairs of different currencies. In theory this means when someone takes a position against the pound, they expect the value to drop in relation to another currency — this time the dollar.

Another way to short currency pairs is by using other financial instruments called derivatives. These effectively allow traders to take a bet on the movement of the underlying asset without owning it.

But this type of trading can cause extreme volatility in markets, especially when lots of people pile into the same trade.

Analyst expect the pound to reach dollar parity soon. Photo: Matt Cardy/Getty
Analyst expect the pound to reach dollar parity soon. Photo: Matt Cardy/Getty

How do hedge funds benefit from a weaker sterling?

A hedge fund is a securities fund which manages various assets, including the pound.

It's a limited partnership of private investors whose money is managed by professional fund managers who use a wide range of strategies like buying stocks for long-term price appreciation but also sell stocks short.

Hedge fund managers buy and sell equities, initiate arbitrage, and trade bonds, currencies, convertible securities, commodities and derivative products to generate returns at a reduced risk.

As they have far larger funds at their disposal compared with the average trader, some fund managers have been accused of reportedly cashing in on a weaker sterling as it fell in value.

Hedge funds who made money would have sold pairs with the base currency GBP before the pound's crash last week, or early on in the fall of sterling against the greenback.

Read more: FTSE hits 17-months low as IMF criticises UK tax plans

Which hedge funds have benefitted from it?

According to a report by The Sunday Times, a source who was at a dinner with hedge fund managers last week, told the newspaper "they were all" allegedly shorting the British currency.

One of the hedge funds that has profited is Crispin Odey’s London-based Odey Asset Management.

Kwarteng previously worked as a consultant to the fund, but Odey said this had not handed him a trading advantage.

The hedge fund tycoon has been taking short positions against sterling and longer-dated gilts for some time in the hope that the market had badly underestimated how long inflation could stay elevated.

Such bets are now paying off as both bonds and the pound were hit following chancellor Kwarteng’s tax-cutting, high borrowing fiscal blitz last week and his comments over further tax cuts.

Odey's main fund reportedly jumped by 145% this year from shorting UK government bonds, according to Reuters.

Edouard de Langlade, founder of macro hedge fund EDL Capital, has also taken a short position against the pound, betting on a fall in the currency and took profits as it weakened.

De Langlade said he has retained a fifth of his wagers against sterling and is also betting against UK stocks in anticipation of higher interest rates, which he believes could eventually reach over 10%.

Computer-driven traders have also gained from the strong selling in UK currency, according to the Financial Times.

The FT also reported that Rotterdam-based Transtrend, which manages $6.3bn in assets, is shorting the pound against a number of other currencies, and also betting against British fixed income instruments.

That has seen the fund's gains rise 7.4% in September, and up 30% so far this year.

Watch: How does inflation affect interest rates?