Cho-Hoi Hui

Price Cointegration between Sovereign CDS and Currency Option Markets in the Financial Crises of 2007-2013

While the US dollar and Japanese yen are considered as safe-haven currencies, both their sovereign credit default swap (CDS) spreads and exchange rate have varied in a wide range since late 2007. This raises the question of interconnectivity between the anticipated sovereign credit risk and the market expectation of the dollar-yen exchange rate. This paper shows evidence of information flow from the sovereign CDS market to the dollar-yen currency option market during the sovereign debt crisis from September 2009 to August 2011 when concerns about sovereign credit risks in the developed economies were triggered. The impact of the US sovereign credit risk on the risk reversal is a separable risk factor in driving the market expectation of the dollar-yen exchange rate after controlling other macro-financial variables. While the Japanese sovereign CDS spread was higher than its US counterpart, its impact on the risk reversal was not significant.The sovereign credit default swap (CDS) spreads and exchange rates of the developed economies including the US, Japan, Switzerland and the eurozone with the first three countries currencies conventionally considered as safe-haven varied in a wide range during the financial crises since late 2007. This raises the question of any interconnectivity between the anticipated sovereign credit risks of these economies and the market expectations of their exchange rates. Using a bivariate vector error-correction model with random coefficients, this paper finds evidence of cointegration and time varying conditional correlation between the prices in the sovereign CDS and currency option markets. This suggests that the relative sovereign credit risk of these developed economies impacts the market expectations of their exchange rates in the long run, but in the short run the impact changes drastically in times of crisis, resulting in drastic and persistent price deviations from their long-run equilibrium amid central banks monetary measures and market turbulence.

Is the Hong Kong Dollar Exchange Rate 'Bounded' in the Convertibility Zone?

The empirical results show that after the introduction of the three refinements to the Linked Exchange Rate system in May 2005 the Hong Kong dollar follows a bounded process that is consistent with a fully credible exchange rate band. The bounded process will limit the movements of the exchange rate to between the strong- and weak-side limits because its variance vanishes at the Convertibility Undertakings making it inaccessible to the limits. The Hong Kong dollar does not show any strong tendency to revert towards the centre of the Convertibility Zone. This is perhaps not surprising as there have been no interventions in the foreign exchange market since May 2005. There may be few forces or incentives for market participants to drive the exchange rate towards 7.80.

Swiss Franc’s One-Sided Target Zone During 2011-2015

On 6 September 2011, a ceiling on the value of the Swiss franc was imposed, at CHF 1.2 per euro. With the continuous weakness of the euro area economy, this exchange rate limit was abandoned on 15 January 2015. This paper proposes a quasi-bounded process for the Swiss franc exchange rate dynamics under a one-sided target zone during this period, in which the exchange rate can breach the strong-side limit under a restricted condition of the relationship between the parameters of the drift term and stochastic part of the process. The empirical results using market data during 6 September 2011 iV 14 January 2015 with a rolling one-year window suggest that this model can describe the dynamics of the Swiss franc under a one-sided target zone, where the drifting force is an increasing function of foreign reserves. While the exchange rate was bounded below the strong-side limit during most of the time, as indicated by its dynamics, the condition for breaching the limit was met in November 2014 using only information until that point, i.e., about two months before abandoning the limit.

Price Disparities between Mainland China’s Onshore and Offshore Financial Markets

As the capital account of Mainland China has yet to be fully liberalized, the offshore financial markets in Hong Kong are beneficial to the development of Mainland China’s trade and financial integration with the rest of the world. However, the institutional separation1 between the onshore and offshore financial markets has created price disparities for the same underlying assets, with prominent examples including the A- and H-shares in the equity markets, the onshore deliverable and offshore nondeliverable renminbi forward exchange-rate markets, and the onshore and offshore renminbi spot exchange-rate markets. Despite increasing integration of the onshore and offshore markets in recent years, significant price disparities continue to exist, and at times, particularly during periods of financial turbulence, they could be fairly large. To gain a better understanding about the causes and implications of such disparities, this chapter aims to shed light on the following issues: (1) why onshore and offshore investors would pay different prices for the same underlying assets; (2) whether the price disparities would converge over time when there are shocks to the markets; and (3) if there exists causation linkages between the two markets.

Measuring Contagion-Induced Funding Liquidity Risk in Sovereign Debt Markets

This paper proposes a model based on probability density functions associated with dynamics of underlying asset prices to measure contagion-induced systemic risk in the market. The two new risk measures with closed-form formulas derived from the model are: (1) the rate of change of the probability of triggering a shock determined by the joint dynamics of prices of systemically important assets/entities and less important ones; and (2) the distress correlation between the two types of assets/entities, which can provide forward-looking signals of such risk. The model is applied to the euro-area sovereign debt crisis and demonstrates how systemic liquidity shocks can build up in the sovereign debt market due to contagion between sovereign risk of small countries (i.e., Portugal) and systemically important countries (i.e., Italy and Spain). A signal of the rate of change of the joint probability appeared in April 2011 before the systemic liquidity shock occurred in November 2011. There exist endogenous critical levels of sovereign spreads, above which the signal materializes.

Capital Management and Leverage of Foreign Bank Subsidiaries in a Host Country: A Case in Hong Kong

The large presence of global banks in Hong Kong offers a well suited empirical setting to study the capital management of foreign bank subsidiaries from a host country perspective. Specifically, this paper uses the trade-off theory of leverage to investigate whether the leverage dynamics of foreign bank subsidiaries in the host country would behave differently to domestic banks. Similar to the behavior uncovered empirically of non-financial firms, we find that the standard determinants of leverage are applicable to banks in Hong Kong. In particular, there is a mean-reverting force which acts as a self-correcting mechanism for their leverage, with over-leveraged banks having a tendency to decrease their leverage, and vice versa. However, the self-correcting mechanism of banks leverage may in times be unduly disturbed by abundant global liquidity, with the effect on foreign bank subsidiaries tangibly higher than that on domestic banks. The externality generated by current abundant global liquidity affecting foreign bank subsidiaries may require the implementation of macro-prudential policies in the host country to contain the risks stemming from the high leverage of banks and external liquidity shocks.

Interest Rate Risk in the Pricing of Banks' Mortgage Lending

Intensive competition among banks in Hong Kong has driven the effective mortgage interest rates down to a historic low of around 2.75 per cent below best lending rate (BLR) with cash rebates of 1 per cent of loan amounts in general since early December 2004.2 This, together with falling interest rates, has brought the average mortgage rate down gradually from over 11 per cent in early 1998 to just over 2 per cent in December 2004 (see Figure 5.1). One key reason why banks can offer such low rates is their extraordinarily low funding cost. The spread of BLR over 3-month Hong Kong Interbank Offered Rate (HIBOR) has been maintained at around 460 basis points (bps) since September 2003, as a result of the abundance of liquidity in the banking sector. At the same time, customers’ deposit rates have also been at very low levels. On average, the spreads of BLR over the average time deposit rate (TDR) and the effective deposit rate (EDR) have been about 500 bps.3