Friday, September 21, 2007

Arbitraging the HKD

"What is the role of arbitrage in HK's exchange rate arrangement?" - Vincent

Arbitrage plays an important role in ensuring that the interest rate in Hong Kong remains close to the value in the United States. To illustrate this point, suppose interest rates in Hong Kong were significantly higher than in the United States. It would then be profitable to borrow large sums of money in the United States, convert them into Hong Kong dollars, and deposit them in the Hong Kong banking system- because the interest income earned on your HKD deposits would exceed the interest that must be repaid on your US dollar loan. When the loan comes due, you would withdraw your HKD deposit, convert it back to USD, repay your USD loan, and have money left over!

Of course there are more efficient ways of taking highly leveraged positions to benefit from any interest rate mis-match. Using currency futures markets, you could take a long position in HKD and a short position in USD- if the exchange rate remains fixed, your profits would be approximately equal to the difference between the interest rates in the two economies, multiplied by the size of your position held.

When investors take advantage of interest rate differentials like this, the very act of arbitraging will move interest rates closer together- borrowing USD will raise the US interest rate, and lending HKD will lower the HK interest rate. So interest rates in HK will remain close to those in the US- adjusted for relevant risks between the two markets.

The above argument only applies to currencies with fixed exchange rates. For most currency pairs, there may be large and persistent differences between interest rates, as taking leveraged positions across currencies is very risky due to exchange rate volatility. Exchange rate movements are often large, and may more than cancel out any gains from trying to arbitrage away interest rate differentials- see the previous story about the volatility of the Canadian dollar. But the presence of exchange rate volatility doesn't stop people trying to profit from interest rate differentials. Strategies designed to take advantage of this are typically referred to as the "Carry Trade." For an earlier discussion about this, see the comments here.


Anonymous said...

Sorry to be overly elementary but what rate in hong kong should be paired against the US discount rate or the fed funds rate? is it HIBOR?

and while not worlds apart, isn’t there generally a small differential between HK and US rates? is this the result of speculation on the HKD or perhaps transaction costs eliminating any arbitrage gains?

thanks, love your blog.

James Yetman said...

Strickly, we should compare like-with-like: in this case, a risk-free rate with a risk-free rate. For example, Hong Kong exchange fund notes (see for more) versus US Government bonds. Both are Government backed, and so should have negligible probability of default.

The difference in rates is likely due to a number of factors:
- the perceived risk that the Hong Kong currency board will be abandoned
- exchange rate volatility (the exchange rate can vary between 7.75 and 7.85, or a little over 1 percent, without any automatic intervention by the HKMA)
- transaction costs, as you mention

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