An alternative approach to defending the Hong Kong dollar
Cheng, Leonard Kwok-Hon
Kwan, Yum K.
Lui, Francis T.
|Summary||The paper reviews the circumstances under which speculative attacks on the currency board of Hong Kong occurred during the Asian financial turmoil. It argues that interest rate arbitrage as a defense mechanism would not function properly unless the risk premium of holding Hong Kong dollar could be reduced by restoration of confidence. A proposal to issue structured notes, or put options to strengthen the currency board is made. Arguments for and against the proposal are reviewed. We show that the 'technical' measures eventually undertaken by the Hong Kong Monetary Authority are analytically equivalent to issuing the structured notes. Empirical tests indicate that interest rate arbitrage had been working properly until the rule-bound currency board had been eroded by discretion introduced by the Monetary Authority. However, after implementing the structured notes proposal, interest rate arbitrage appeared to be effective again.|
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