Laurence Fung

Assessing the Integration of Asia's Equity and Bond Markets

Since the Asian financial crisis in 1997-1998, economies in the region have made efforts to diversify their reliance on the banking sector in favour of other financial intermediaries such as equities and bonds. Despite the recent development, the degree of intra-regional financial integration appears to lag behind the increase in trade. Such asymmetric development in economic and financial integration may have implications on financial stability. Therefore, it is of interest to monitor the development and progress of financial market integration in the region. Unlike most studies which focus on either the equity market or the bond market integration, this study compares the different experiences of integration of the equity and the government bond markets in the region. To do so, we construct various indicators for measuring different dimensions of equity and bond market integration. A combined use of these indicators would give policy makers a more balanced picture regarding the general trend of equity and bond market integration in the region. Furthermore, the examination of the co-movement between equity and bond returns at the economy and the regional levels may also shed light on the degree of integration in these markets.

Comparing Forecast Performance of Exchange Rate Models

Exchange-rate movement is regularly monitored by central banks for macroeconomic-analysis and market-surveillance purposes. Notwithstanding the pioneering study of Meese and Rogoff (1983), which shows the superiority of the random-walk model in out-of-sample exchange-rate forecast, there is some evidence that exchange-rate movement may be predictable at longer time horizons. This study compares the forecast performance of the Purchasing Power Parity model, Uncovered Interest Rate Parity model, Sticky Price Monetary model, the model based on the Bayesian Model Averaging technique, and a combined forecast of all the above models with benchmarks given by the random-walk model and the historical average return. Empirical results suggest that the combined forecast outperforms the benchmarks and generally yields better results than relying on a single model.

Assessing the Credibility of the Convertibility Zone of the Hong Kong Dollar

The features under the two-sided Convertibility Zone of the Hong Kong dollar resemble in many ways the target zone exchange rate regime in the literature. Following Tronzano et al. (2000), this paper utilises a Bayesian extension of the Svensson (1991) test, which takes into account the exchange rate movement and the differential between domestic and foreign interest rates, to assess the credibility of the Convertibility Zone since it was introduced in May 2005. The empirical evidence suggests that the Hong Kong Monetary Authority has been successful in building a high degree of credibility in maintaining the Convertibility Zone.

A Study on the Transmission of Money Market Tensions in EMEAP Economies during the Credit Crisis of 2007-2008

The recent tension in the interbank markets following the global financial crisis has raised concerns about the turbulence in interbank markets. This paper utilises two widely used indicators for measuring interbank stress (the interbank rate less the Overnight Index Swap rate and the interbank rate less the yield of government securities) to examine the transmission of interbank tension from the US dollar to nine interbank markets in the EMEAP economies. Using a vector autoregression model, we show that during the credit crisis of 2007 - 2008, the distress in the US dollar money market had a material impact with durations of seven to 13 days on the interbank markets for the Hong Kong dollar, Japanese yen, Australian dollar and New Zealand dollar. Moreover, based on a bivariate regime switching ARCH model, we also find evidence of volatility co-movement between the interbank stress indicator of the US dollar and that of the Hong Kong dollar, Japanese yen, Australian dollar, New Zealand dollar, Korean won and Singapore dollar during the crisis. The expected duration when two money markets are both in a high-volatility state is estimated to be as long as seven days. The short-lived impact on the EMEAP economies from a shock in the US dollar money market can be attributed to the policy actions taken by central banks and monetary authorities in the region and the coordinated efforts by policy makers worldwide to contain the credit crisis.

Assessing Financial Market Integration in Asia - Equity and Bond Markets

Since the Asian financial crisis in 1997-1998, economies in the region have made efforts to diversify their reliance on the banking sector in favour of other financial intermediaries such as equities and bonds. Despite the recent development, the degree of intra-regional financial integration appears to lag behind the increase in trade. Such asymmetric development in economic and financial integration may have implications on financial stability. Therefore, it is of interest to monitor the development and progress of financial market integration in the region. Unlike most studies which focus on either the equity market or the bond market integration, this study compares the different experiences of integration of the equity and the government bond markets in the region. To do so, we construct various indicators for measuring different dimensions of equity and bond market integration. A combined use of these indicators would give policy makers a more balanced picture regarding the general trend of equity and bond market integration in the region. Our empirical results broadly show that a lot of progress has been achieved over the years from 1994 to 2001 in the integration among the Asian equity markets. After slowing down between 2002 and 2006, the equity market integration process picked up again in 2007-08. Meanwhile, the degree of integration in the sovereign (government) bond markets in Asia remains low and very little progress has taken place since 2002.

A Structural Approach to Assessing the Credit Risk of Hong Kong's Corporate Sector

Given the close relationship between corporate vulnerabilities and the occurrence of banking and financial crises, regulators need to adopt a financial stability monitoring and surveillance framework which includes the assessment of the credit risk of the corporate sector. This paper illustrates how to assess the default risk of the non-financial corporate sector in Hong Kong by constructing an aggregate market indicator of default probabilities (PDs) using a structural approach (i.e. the Merton model). Rather than relying solely on accounting data, the Merton model quantifies the default risk of the corporate sector as well as credit conditions of different industry sectors using up-to-date market-based information such as equity prices. The aggregate PD of the non-financial constituent companies of the Hang Seng Index rose sharply a few months before the burst of the internet bubble in late February 2000. This appears to suggest that the PD may serve as an early warning signal for monitoring the potential vulnerability in the corporate sector. The study shows that the aggregate PDs derived from the Merton approach reflect the corporate default risk arising from economic shocks. The industry-specific PDs reveal areas of potential weaknesses in different industry sectors. Overall, the PD has proven to be an effective monitoring tool to gauge vulnerability in the corporate sector.

Dislocations in FX Swap and Money Markets in Hong Kong and Policy Actions during the Financial Crisis of 2008

When US dollar interbank markets malfunctioned during the global financial crisis of 2008, many non-US financial institutions relied heavily on the foreign-exchange (FX) swap markets for US-dollar funds. This one-sided market induced a risk premium of the FX swap-implied US-dollar rate across a range of funding currencies, i.e. a deviation from the covered interest parity (CIP) condition. The turbulence in the global interbank markets therefore spilled over to the FX swap markets, including that in Hong Kong. This paper analyses the effectiveness of the policy actions taken by the Hong Kong Monetary Authority and the Government in responding to the dislocations and stress in the local interbank and FX swap markets. Our results show that the policy actions effectively ameliorated the FX swap market dislocations after the failure of Lehman Brothers, i.e. reducing the CIP deviations.

Exchange Rate Risk Premiums in Hong Kong Dollar: A Signal-Extraction Approach

Forward exchange rates convey information about the risk premiums of the currency exposures of the investors. The extraction of these risk premiums provides market information for the expected future values of a currency, which may be useful for policymakers in their market surveillance and monitoring. This study utilises a state-space model and the Kalman-filtering technique to estimate risk premiums of Hong Kong dollar from the forward exchange market from 1996 to 2005. The estimated risk premiums of the 12-month forward contract were as high as 3.4% of the spot exchange rate during the Asian financial crisis in 1998. The study also finds that the risk premiums have reverted from a discount in late 2004 to close to zero in mid-2005, reflecting that the appreciation pressure on the Hong Kong dollar along with the speculation on the revaluation of the renminbi in early 2005 has subsided after the introduction of the three refinements to the operation of the Linked Exchange Rate system in May 2005 and the reform of the renminbi exchange rate regime in July 2005. The forward exchange rates, after taking the estimated risk premiums into account, do not have a good forecasting capability for the future spot exchange rates. Between the two financial factors that drive the risk premiums in the Hong Kong dollar forward rates, the renminbi non-deliverable forward rates appear to have a larger impact than the Aggregate Balance of the banking system. Nonetheless, both factors are important for monitoring the risk premiums of the Hong Kong dollar exchange rate.

Return and Volatility Spillovers in Hong Kong Financial Markets

This paper studies the return and volatility spillovers between the stock market, the Exchange Fund Notes market and the Hong Kong dollar forward exchange market. Based on a bivariate GARCH model that specifies exogenous influences in the conditional mean and variance equations, this study examines the source and magnitude of the return and volatility spillover between financial markets. The estimation results suggest that while the pattern of return spillover is not clear, there is some evidence of volatility transmissions between selected financial markets in Hong Kong. In terms of the economic impact, however, most of these spillovers are minimal. When financial markets are turbulent, the return spillover from the forward exchange market to the stock market and the volatility transmission from the forward exchange market to the Exchange Fund Notes market can be substantial. As such, close monitoring of the fluctuations in the forward exchange market is warranted.