The Hong Kong Monetary Authority (HKMA) is the central bank for Hong Kong. Recently, it bought 13.8 billion HKD to keep the currency stable because the HKD was near the lower end of its exchange rate limit against the USD. Since 1983, the HKD has been linked to the U.S. dollar through a system that maintains exchange rate stability, keeping the HKD at about 7.80 per U.S. dollar. It can trade in a range from 7.75 to 7.85.

Understanding The Linked Exchange Rate System

To keep the HKD within this range, the HKMA uses an automatic adjustment system. Under the Currency Board System, every HKD issued is backed by U.S. dollar reserves. Changes in foreign exchange flow directly affect the monetary base. If the HKD gets close to the strong side (7.75), the HKMA sells HKD and buys U.S. dollars. If it nears the weak side (7.85), the HKMA buys HKD and sells U.S. dollars. This helps manage liquidity and keep the HKD stable within its range. The recent purchase of 13.8 billion HKD came when the currency was nearing the low end of its range, at 7.85. This action was not spontaneous; it followed a long-established rule. The exchange rate system, established four decades ago, automatically handles interventions based on set rules. By buying HKD and selling U.S. dollars, the HKMA aimed to tighten liquidity in the interbank market. This action led to a spike in overnight HKD funding costs, effectively pulling excess cash from circulation. As a result, market participants had to reevaluate short-term positions in currency and interest rate products. These steps reflect broader market pressures, mainly driven by differences in interest rates between the U.S. and Hong Kong. The U.S. Federal Reserve’s ongoing interest rate hikes have led to wider spreads, causing capital to favor higher-yielding USD assets. This trend puts downward pressure on the HKD within its trading band. Yam, in previous speeches, highlighted that any deviation from the set rules could change market attitudes. Therefore, we’re not just observing regular currency operations; we’re seeing a concerted effort to maintain market confidence. Relaxing these rules would invite speculation.

The Impact On Derivative Markets

For derivative traders, the effects of these interventions are significant. Changes in Hong Kong’s monetary base can influence forward points, swap rates, and implied volatility around critical expiry periods. We’ve already noticed meaningful shifts in forward points over the last two weeks, illustrating how currency pegging affects more complex financial products. Chan has pointed out that currency market pressures often align with differences in global monetary policies. These discrepancies influence trading decisions and liquidity in shorter-dated contracts. Looking ahead, we expect that selling USD will continue, especially if U.S. economic data strengthens the case for longer-lasting higher rates. Market-based probability estimates for Fed Fund futures indicate a strong belief in sustained pauses or further rate increases. From our perspective, the HKMA’s actions will likely be reactive, responding whenever the linked rate approaches its limits. It only takes slight changes in pricing to adjust the entire setup for structured options traded in Hong Kong. We are currently monitoring how liquidity constraints affect equity-linked structured products hedged through FX forwards. These products are sensitive—not only to spot rates but also to maturity spreads. Unwinding or resetting delta hedges may become costly if local short-term rates stay high due to these interventions. Lee has previously noted that tighter local financial conditions impact commercial lending profitability. Consequently, participants in the market must reassess their risk pricing—especially for trades confined to narrow spreads that depend on smooth HKD funding. As funding costs adjust and more interventions occur, we anticipate an increase in broader volatility measures. While still lower than in other global markets, any rise in Hong Kong’s short-term volatility will attract attention. Such changes could influence foreign exchange implied volatility and pricing of dependent derivatives, compelling dealers to adopt more cautious assumptions. In this environment, adjusting exposures, monitoring forward curve slopes, and reviewing cross-currency basis should be immediate considerations, not afterthoughts. Timing is crucial—settlement cycles and margin constraints demand stricter risk control during weeks when central bank activity is evident. Create your live VT Markets account and start trading now.

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