Question: Answer the questions related to the following case study.
HKMA AND THE HEDGE FUNDS, 1998
The Hong Kong Monetary Authority (HKMA) has been in the news because of you and your friends, hedge fund managers. In 1998, you are convinced of the following:
1. The HK$ is overvalued by about 20% against the US$.
2. Hong Kong's economy is based on the real estate industry.
3. High interest rates cannot be tolerated by property developers (who incidentally are among Hong Kong's biggest businesses) and by the financial institutions.
4. Hong Kong's economy has entered a recession. You decide to speculate on Hong Kong's economy with a "double play" that is made possible by the mechanics of the currency board system. You will face the HKMA as an adversary during this "play." You are provided some background readings. You can also have the descriptions of various futures contracts that you may need for your activities as a hedge fund manager. Any additional data that you need should be searched for in the Internet. Answer the following questions:
1. What is the rationale of your double-play strategy?
2. In particular, how are HIBOR, HSI, and HSI futures related to each other?
3. Display your position explicitly using precise futures contract data.
4. How much will your position cost during 1 year?
5. How do you plan to roll your position over?
6. Looking back, did Hong Kong drop the peg?
Hedge Funds Still Bet the Currency's Peg Goes
HONG KONG-The stock market continued to rally last week in the belief the government is buying stocks to drive currency speculators out of the financial markets, though shares ended lower on Friday on profit-taking. Despite the earlier rally, Hong Kong's economy still is worsening; the stock market hit a 5-year low 2 weeks ago, and betting against the Hong Kong dollar is a cheap and easy wager for speculators. The government maintains that big hedge funds that wager huge sums in global markets had been scooping up big profits by attacking both the Hong Kong dollar and the stock market. Under this city's pegged-currency system, when speculators attack the Hong Kong dollar by selling it, that automatically boosts interest rates. Higher rates lure more investors to park their money in Hong Kong, boosting the currency. But they also slam the stock market because rising rates hurt companies' abilities to borrow and expand. Speculators make money in a falling stock market by short-selling shares-selling borrowed shares in expectation that their price will fall and that the shares can be replaced more cheaply.
The difference is the short-seller's profit. "A lot of hedge funds which operate independently happen to believe that the Hong Kong dollar is overvalued" relative to the weak economy and to other Asian currencies, said Bill Kaye, managing director of hedge fund outfit Pacific Group Ltd. Mr. Kaye points to Singapore where, because of the Singapore dollar's depreciation in the past year, office rents are now 30% cheaper than they are in Hong Kong, increasing the pressure on Hong Kong to let its currency fall so it can remain competitive. Hedge funds, meanwhile, "are willing to take the risk they could lose money for some period," he said, while they bet Hong Kong will drop its 15-year-old policy of pegging the local currency at 7.80 Hong Kong dollars to the US dollar. These funds believe they can wager hundreds of millions of US dollars with relatively little risk. Here's why: If a hedge fund bets the Hong Kong dollar will be toppled from its peg, it's a one-way bet, according to managers of such funds.
That's because if the local dollar is dislodged from its peg, it is likely only to fall. And the only risk to hedge funds is that the peg remains, in which case they would lose only their initial cost of entering the trade to sell Hong Kong dollars in the future through forward contracts. That cost can be low, permitting a hedge fund to eat a loss and make the same bet all over again. When a hedge fund enters a contract to sell Hong Kong dollars in, say, a year's time, it is committed to buying Hong Kong dollars to exchange for US dollars in 12 months. If the currency peg holds, the cost of replacing the Hong Kong dollars it has sold is essentially the difference in 12-month interest rates between the United States and Hong Kong. On Thursday, that difference in interbank interest rates was about 6.3 percentage points. So a fund manager making a US$1 million bet Thursday against the Hong Kong dollar would have paid 6.3%, or US$63,000. Whether a fund manager wanted to make that trade depends on the odds he assigned to the likelihood of the Hong Kong dollar being knocked off its peg and how much he expected it then to depreciate. If he believed the peg would depreciate about 30%, as a number of hedge fund managers do, then it would have made sense to enter the trade if he thought there was a one-in-four chance of the peg going in a year. That's because the cost of making the trade-US$63,000-is less than one-fourth of the potential profit of a 30% depreciation, or US$300,000. For those who believe the peg might go, "it's a pretty good trade," said Mr. Kaye, the hedge fund manager. He said that in recent months, he hasn't shorted Hong Kong stocks or the currency (Wall Street Journal, August 24, 1998).