The Price Discovery Puzzle in Offshore Yuan Trading: Different Contributions for Different Contracts

• DOI: http://doi.org/10.1002/fut.21575
• Author: David K. Ding,Michael R. Williams,Yiuman Tse
• Date: 01 February 2014
• Published date: 01 February 2014

THE PRICE DISCOVERY PUZZLE IN OFFSHORE

YUAN TRADING:DIFFERENT CONTRIBUTIONS

FOR DIFFERENT CONTRACTS

DAVID K. DING*, YIUMAN TSE and MICHAEL R. WILLIAMS

The People’s Bank of China (PBC) lifted yuan trading restrictions in July of 2010 that led to

offshore yuan spot trading in Hong Kong. Based on causality analyses, we find that price

discovery is absent between the onshore and offshore spot markets. However, we document the

presence of price discovery between onshore spot and offshore nondeliverable forward (NDF)

rates. These seemingly inconsistent results present a puzzle wherein one offshore market

appears to be more informationally integrated with the onshore market than another. We

conclude that price discovery differences in the offshore markets stem from the offshore spot

and forward contracts tracking different aspects of yuan rates (e.g., the offshore nondeliverable

rate tracks onshore spot rates whereas the offshore spot rate tracks onshore interest rates).

Moreover, the introduction of offshore spot trading in Hong Kong has led to an increase in

cross‐market price discovery between onshore spot and offshore NDF rates. © 2012 Wiley

Periodicals, Inc. Jrl Fut Mark 34:103–123, 2014

1. INTRODUCTION

We examine the cross‐market price discovery impact of introducing offshore yuan spot trading

in Hong Kong. Although Chinese renminbi (RMB) deposits have been allowed in Hong Kong

since 2004, the RMB became officially deliverable offshore in July 2010. The introduction of

offshore spot trading is only one of many currency liberalizations taken by China within the

past decade. The first major innovation occurred in 2004 when Hong Kong residents were

allowed to open yuan‐denominated accounts (Yiu, 2010). This action was followed up by the

switching of the RMB from a fixed to managed‐floating exchange rate in July 2005

(Staff, 2010). Other liberalizations include China allowing trade to be settled in yuan in

July 2009 (Ren & Yiu, 2010) and allowing cross‐border trade settlement in yuan between all

foreign entities and 20 regions within China in June 2010 (Jiang, 2010).

Despite the prior innovations, few were as significant as the authorizing of offshore spot

trading in Hong Kong. Specifically, on July 19, 2010, the People’s Bank of China (PBC) and

the Hong Kong Monetary Authority (HKMA) signed a Memorandum of Cooperation, which

David K. Ding is a Professor of Finance at the School of Economics and Finance, Massey University, Albany,

Auckland, New Zealand and Lee Kong Chian School of Business, Singapore Management University,

Singapore. Yiuman Tse is the Peter G. Schick Professor of Finance at the Department of Finance and Legal

Studies, University of Missouri—St. Louis, St. Louis, Missouri. Michael R. Williams is an Assistant Professor

of Finance at the College of Business, Public Administration, Governors State University, University Park,

Illinois.

*Correspondence author, School of Economics and Finance, College of Business, Massey University, 0632 Albany,

Auckland, New Zealand. Tel: (64) 9 414 0800 ext 9465, Fax: (64) 9 441 8177, e‐mail: d.ding@massey.ac.nz

Received October 2011; Accepted June 2012

The Journal of Futures Markets, Vol. 34, No. 2, 103–123 (2014)

© 2012 Wiley Periodicals, Inc.

Published online 23 July 2012 in Wiley Online Library (wileyonlinelibrary.com).

DOI: 10.1002/fut.21575

allows Hong Kong’sfinancial institutions to open yuan‐based accounts where individuals,

including foreigners, are able to transfer funds to and from these accounts. Further, Hong

Kong banks are allowed to deal directly in the yuan as opposed to using the PBC as a clearing

agency. Finally, Hong Kong’sfinancial institutions have permission to offer yuan‐

denominated financial products, for example, securitized loans, interest rate swaps, and

yuan‐based insurance (Holland, 2010; Jiang, 2010; Pomfret, 2010). While account holders

are limited to exchanging, at most, 4,000 yuan daily (Ren & Yiu, 2010), this step toward

liberalization is significant given that offshore yuan delivery was previously forbidden and that

foreign investors could only participate in the offshore nondeliverable forward (NDF) market.

Since the introduction of the offshore spot rate, RMB deposits in Hong Kong have

increased to 510 billion yuan in June 2011. Further, daily offshore spot trading volume has

expanded from a negligible amount to $1.3 billion daily (Cookson, 2011). Although banks

such as HSBC offer additional yuan trading services in the United States, Japan, and

Singapore, the bulk of trades are conducted in Hong Kong given its proximity and shared time

zone with the Chinese mainland as well as its deeper levels of liquidity (Yiu, 2011a). Further,

innovation in the offshore spot market has proceeded at a rapid pace with ICAP and

Thompson Reuters introducing electronic trading in the Hong Kong yuan in September 2010

and Deutsche Bank introducing their own electronic platform in February 2011. Finally,

European‐style offshore yuan options became available in April 2011 (Staff, 2011).

Given these liberalizations and innovations, one would expect a fairly robust relationship

between the onshore spot (CNY) and offshore spot (CNH) rates. We find that, despite

increasing trading activity and interest, CNY and CNH returns provide little cross‐explanatory

power for each other. Further, the cross‐market return impact is economically insignificant.

Thus, the onshore and offshore spot markets provide little price discovery to each other. On

the other hand, we find that offshore NDF returns have a significant and equal explanatory

power for CNY returns (and vice versa). Moreover, we find that price discovery between the

NDF and CNY increases after the introduction of the CNH.

Our results initially present a puzzle in that price discovery exists for the NDF exchange

rate that is restricted to foreign participants and is settled in a foreign currency whereas the

onshore exchange rate (CNY) has little linkage with the offshore exchange rate (CNH). We

conclude that this puzzle arises from NDF rates being linked with onshore exchange rates (i.e.,

the NDF acts as a futures contract on the CNY) whereas CNH rates are linked with onshore

interest rates. Thus, different offshore rates are connected in different ways to the onshore

spot market leading each to have a different information relationship with the onshore spot

rate. Further, the increased NDF/CNY explanatory power after the introduction of the CNH is

due to CNH rates completing the forward market, which previously had no underlying spot

rate.

2. BACKGROUND

2.1. Offshore Spot Market (CNH)

The CNH is traded in the Hong Kong interbank market and on selected electronic platforms.

Relative to other offshore RMB products, the CNH is relatively illiquid with about $1.3 billion

in daily trading activity (the NDF has a daily trading volume of about $3 billion;

Cookson, 2011; Wallace, 2011). With the July 19, 2010 agreement, the CNH became

deliverable offshore whereby CNH funds can be transferred among the accounts of banks and

individuals. CNH pricing is influenced by individual/resident purchases, trade settlements,

central bank swaps, and more importantly USD/RMB money market interest rates. Also, the

104 Ding, Tse, and Williams