Do Derivative Markets Contain Useful Information for Signaling “Hot Money” Flows?

• Published date: 01 June 2017
• Author: Robert I. Webb,Wing H. Chan,Joseph K. W. Fung
• DOI: http://doi.org/10.1111/ajfs.12178
• Date: 01 June 2017

Do Derivative Markets Contain Useful

Information for Signaling “Hot Money”

Flows?*

Joseph K. W. Fung**

Hong Kong Institute for Monetary Research, Hong Kong Baptist University, China

Robert I. Webb

University of Virginia, United States

Wing H. Chan

City University of Hong Kong, China and Wilfrid Laurier University, Canada

Received 29 June 2016; Accepted 29 December 2016

Abstract

This study examines whether information from derivative markets is useful for signaling “hot

money” and other large capital flows in an economy where the monetary authority pursues a

policy of exchange rate stability. It examines the information content of Hong Kong-traded

derivative securities for signaling changes in the aggregate balance of the Hong Kong banking

system during a period of intense initial public offering activity and speculation on the reval-

uation of the renminbi. The impact of the Hong Kong Monetary Authority’s (HKMA) Con-

vertibility Undertakings on the dynamic relationships among capital flows, stock market

volatility, and stock market turnover is examined.

Keywords Hot money; Currency board; Derivative markets; Capital flows

JEL Classification: E58, F32, G15

*Joseph Fung and Robert Webb gratefully acknowledge the receipt of financial support from

the Hong Kong Institute for Monetary Research for this research study, which has also bene-

fited from helpful comments from Matthew Yiu and Kitty Lai. We also thank Kenneth Chow

of the institute for assistance in compiling the data and Sanry Che for her excellent research

assistance. The views expressed in this paper are those of the authors, and do not necessarily

reflect those of the Hong Kong Institute for Monetary Research, its Council of Advisors, or

the Board of Directors.

**Corresponding author: Joseph K. W. Fung, Department of Finance and Decision Sciences,

School of Business, Hong Kong Baptist University, WLB 817, 34 Renfrew Road Kowloon

Tong, Hong Kong, SAR China. Tel: +852-3411-7559, email: jfung@hkbu.edu.hk.

Asia-Pacific Journal of Financial Studies (2017) 46, 491–527 doi:10.1111/ajfs.12178

©2017 Korean Securities Association 491

1. Introduction

It is widely recognized that “hot money” and other large movements of capital,

both into and out of a country, can exert a significant impact on financial markets

and the overall economy. Large capital inflows exert upward pressure on the

exchange rate by raising the demand for the local currency, decrease interest rates

by increasing the supply of credit, increase asset market turnover, and bid up the

prices of both investment and consumption goods. Conversely, large capital out-

flows exert downward pressure on the local currency’s exchange rate and asset

prices, promote greater short-run market turnover, and lead to higher interest rates

as the supply of credit decreases. The volatility of asset prices may also be affected

by capital flows.

The impact of hot money on financial markets is especially easy to see when a

monetary authority pursues a stable exchange rate policy via a currency board

because the exchange rate is not allowed to adjust much. If the mechanical nature

of a currency board system leads to predictable effects on interest rates and asset

prices following a large capital flow, the question that naturally arises is whether

derivative markets are able to anticipate some of the likely financial market

response.

The experience of Hong Kong is especially interesting because its de facto cen-

tral bank, the Hong Kong Monetary Authority (HKMA), employs a currency board

system (the “Linked Exchange Rate System”); the territory has active derivative

markets; and hot money may arrive due to a change in the perceived fund amentals

of Hong Kong and the Chinese Mainland, or as a “play” on the Chinese renmi nbi

(RMB).

There is substantial evidence in the financial economic literature that derivative

market prices contain significant information as a recent article by Webb (2016)

reports. This study attempts to ascertain whether information from Hong Kong’s

derivative markets is useful for signaling hot money and other large capital flows

during a commonly agreed period of intense initial public offering (IPO) activity

and speculation on a revaluation of the RMB.

1

The choice of time period is deliber-

ate. If derivative markets contain useful information in signaling hot money flows,

the information should be readily apparent during a period of intense speculation.

1

Some observers attribute the use of the Hong Kong dollar (HKD) as a vehicle to speculate

on the RMB to the communiqu

e from the G-7 Finance Ministers conference in Dubai on

September 20, 2003. The communiqu

e stated: “We reaffirm that exchange rates should reflect

economic fundamentals. We continue to monitor exchange markets closely and cooperate as

appropriate. In this context, we emphasize that more flexibility in exchange rates is desirable

for major countries or economic areas to promote smooth and widespread adjustments in

the international financial system, based on market mechanisms.” Many market participants

believed that the acquisition of HKD-denominated assets was a way to play the expected

appreciation of the RMB against the US dollar (USD). The HKD strengthened sharply after

the conference and hit 7.711 to the USD on October 7, 2003.

J. K. W. Fung et al.

492 ©2017 Korean Securities Association

Several derivative markets are examined, including changes in the Hong Kong

Inter-Bank Offer Rate (HIBOR) futures prices, changes in HKD forward prices,

changes in non-deliverable forward prices on the RMB, and changes in the implied

volatility of Hang Seng stock index futures options.

1.1. The Hong Kong Monetary Authority and the Currency Board System

The Hong Kong government implemented the current currency board system—the

Linked Exchange Rate System—in 1983. The system commits the HKMA to main-

tain the exchange rate of the HKD to the USD within narrow bounds.

2

The HKMA

stands ready to buy and sell USDs and to absorb any impact that capital flows may

have on the linked exchange rate.

3

When a local bank receives a USD deposit and

(the client) wants to convert it into HKDs, the HKMA will buy the USDs at the

linked rate and credit the clearing account of the bank with an equivalent amount

of HKDs.

4

This increases the clearing balance of the bank and the aggregate balance

of the banking system—the sum of all bank clearing balances on deposit at the

HKMA. The purchase of HKDs puts upward pressure on the exchange rate while

the resultant expansion of the monetary base puts downward pressure on interest

rates. Similarly, if the client withdraws the USD-denominated deposit, the bank sells

HKDs to the HKMA at the linked rate and the HKMA debits the clearing account

of the bank and credits the bank with an equivalent amount of USDs. This reduces

the clearing balance of the bank and also the aggregate balance.

5

The sale of HKDs

puts downward pressure on the exchange rate and, with the contraction of the

monetary base, upward pressure on interest rates. Hence, the aggregate balance

increases with capital inflows, decreases with capital outflows, and can impact

exchange and interest rates. Under the Convertibility Undertakings, there is no limit

on the maximum size of the aggregate balance.

6

We use daily changes in the aggregate balance as a proxy for hot money flows.

The behavior of the daily closing value of the aggregate balance surrounding the

introduction of the Convertibility Undertakings is depicted in Figure 1. As is readily

apparent, the aggregate balance rose sharply in the last quarter of 2003 and peaked

2

This commitment is known as Convertibility Undertakings. The range in which the HKD

exchange rate may fluctuate is known as the convertibility zone.

3

Under the currency board system, the entire monetary base in Hong Kong has to be at least

100% backed by USD-denominated assets.

4

All licensed banks in Hong Kong have a clearing account with the HKMA. The balance that

each bank has in the account is for inter-bank settlement purposes. The aggregate balance is

also a measure of the overall level of interbank liquidity.

5

Licensed Hong Kong banks can also borrow funds intraday from the HKMA via the liquid-

ity adjustment window or overnight via the discount window. In both cases, the bank must

pledge collateral as security.

6

The aggregate balance reached HKD52 billion in January of 2004 according to Yam (2004).

Derivative Markets and “Hot Money” Flows

©2017 Korean Securities Association 493