SINGAPORE/HONG KONG, Dec 5 (Reuters) – This is what markets call “tail risk”: a highly unlikely scenario in which Hong Kong’s currency peg suddenly collapses. Still, market prices suggest betting on such a shock is building in the hedge fund world, and some traders say that makes a lot of sense.
Billionaire fund manager Bill Ackman last month went public with his bet that the days of the 39-year peg of the Hong Kong dollar to the US dollar are numbered.
Ripples in the derivatives market imply that he is not alone, as “macro” trading – or betting on big global shifts – is back in vogue and the prospect of reaping a huge reward for relatively low risk. low revives a still unsuccessful trade.
Most fundamental analysts say such bets are foolish, pointing to the city’s still massive reserves and support from China.
But they can be relatively cheap and even profitable even if the peg remains intact, and they buy insurance against improbable but not impossible chains of events, such as a sudden explosion in China, a devaluation or a geopolitical chill.
“For me, the peg of the Hong Kong dollar is like a delayed or delayed bet against China,” said Diego Parrilla, who runs Quadriga Igneo, a $240 million fund designed to take advantage of market turbulence.
“You take advantage of extreme market complacency,” he said. “The downside is limited to the premium spent…I risk very little and can gain a lot.”
Saba Capital founder Boaz Weinstein is also positioned for a break from the peg, and said on Twitter the payout could be “over 200 to 1”.
The cost and size of these positions are unclear, but Ackman and Parrilla said their bets were placed using options.
Options are contracts that, for an upfront fee, allow investors to bet on asset price movements without the risk of losses beyond the upfront fee, and there are signs that those bets are picking up.
A measure of the spread, or bias, between puts and calls in the options market has hit its highest level in about three years in favor of US dollar calls, suggesting betting against the Hong Kong dollar become a bit more congested.
The Hong Kong dollar has been pegged in a narrow band between 7.75 and 7.85 per greenback for nearly four decades. Its stability and fungibility have been the major foundations of Hong Kong’s success as a financial center and a hub for money flows to and from China.
THE STATUS QUO
China rarely comments on the peg, but in 2014 its cabinet said the government would “firmly support” Hong Kong in maintaining the peg and the city’s stability. The Hong Kong Monetary Authority (HKMA) says it has “no need or intention” to change the system and has sufficient reserves to defend the peg.
The HKMA maintains the peg by moving interest rates in line with the United States and through currency intervention, which drains liquidity from the system and is designed to drive up local rates until the entries stabilize the currency.
Transactions betting against the peg, perhaps encouraged by spectacular examples of broken pegs in the past in places like Switzerland or Argentina, seem to resurface every time US interest rates rise, and the reasoning of investors varies.
A possible outcome, rather than a clean break, is a re-pegging of the dollar to the Chinese yuan.
Still, Chinese and Hong Kong officials have never hinted a change is on the cards, and analysts don’t think the discomfort outweighs the usefulness of parity.
“As long as capital controls remain in China…Hong Kong still offers a good window for money inflows and outflows,” said Redmond Wong, Greater China strategist at Saxo Markets. “I don’t see why there’s an immediate trigger…to change the status quo.”
Even bad peg break bets can be profitable and protected by the peg itself.
If, rather than options, traders are betting against the peg using futures – another contract where the parties agree to exchange currencies in the future – the position can make money if the dollar’s Hong Kong is not growing. Losses would also be capped by the strong part of the currency band.
In the short term, the market moves against this style of trading as local interest rates and the Hong Kong dollar rise.
But some investors still see value in longer-term contracts. A one-year futures contract can remain profitable if spot prices are below around 7.78 to the dollar, where the currency was trading on Friday, a year from now.
“The distant futures market is still pricing US rates higher than Hong Kong rates,” said Mukesh Dave, founder and CIO of Singapore-based Aravali Asset Management, which in theory should contain Hong dollar gains. Kong.
The cost of a one-year US$1 million notional call option with a strike price of HK$7.95, for comparison, is about 55 basis points or $5,500 , according to Dave.
Although more expensive up front and with no prospect of profit if the peg remains, bettors seem to prefer the options route and say it offers a better risk-reward ratio.
John Floyd, who runs his own New Jersey hedge fund and recommended options to short the yuan and Hong Kong dollar in February, said a futures position would be dangerously exposed if China ended the tie-in with a conversion into yuan at a higher price than the currency. bandaged.
“The only way to express this trade that both controls downside risk and allows upside profit…is through long options exposure.”
Additional reporting by Vidya Ranganathan in Singapore. Editing by Kim Coghill
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