Peter's Perspective
22nd January 2016 by Peter Churchouse

Betting Against a Currency Peg Can Be Hugely Profitable… But Not This Time…

It’s been nearly two decades since I’ve seen currencies come under as much speculative attack as they are today.

We’ve seen plenty of individual or regional examples over the years; the British Pound in late 1992 (George Soros’ famous and profitable victory over the British government) and the Asian Financial Crisis of 1997.

But today currency mayhem is global.

A key difference is that there are much fewer ‘pegged’ currency regimes now.

In the mid-1990’s, the Thai baht, Indonesian rupiah, Chinese renminbi, Brazilian real and Russian ruble all traded at either fixed rates or within tight bands.

Nowadays, many of them float… or are at least much more open to market forces.

Betting against those currencies is relatively straightforward. And it’s been profitable.

The Brazilian real, Russian ruble and Indonesian rupiah are down 37%, 23% and 10% respectively in the past year against the dollar for example.

Much of the low-hanging fruit of shorting EM currencies has been picked. So where else to turn?

Pegged currencies.

Let me hand over to Tama to explain why pegged currencies can be so attractive to currency speculators.

~

Allow me [Tama] to apologise in advance. I’ll try and make this as simple as possible.

If I want to bet against a currency (i.e. speculate that it will depreciate against say the U.S. dollar), I have two main ways of placing my bet; using FX options or FX forwards.

FX forwards are just an agreement to exchange 2 currencies at a pre-determined FX rate in the future.

[The forward rate is largely determined by interest rates, but I won’t go into that now]

In a fixed (or pegged) currency regime, the forward rate should be close to the pegged rate.

Because, hey, it’s fixed! The currency isn’t supposed to move!

Let’s look at Saudi Arabia. Since 1986 the Saudi riyal (SAR) has been pegged at 3.75 to the dollar.

Since 1988, the weakest daily close against the dollar has been 3.77 and the strongest was 3.705.

So, over nearly 3 decades, it’s only depreciated by 0.51% at most. And it’s strengthened by just 1.21%.

The currency peg has held. It hasn’t budged at all.

I won’t bother showing a multi-decade chart of the USDSAR exchange rate… it’s just a horizontal line.

So, if I want to place a big bet on the riyal, then I can just trade in the forward market.
Let’s say I think the peg will be removed and the riyal will depreciate.

I simply enter an FX forward contract locking in a future currency rate. As there is a peg in place, that forward rate should be around 3.75.

In this contact, I agree to pay 3.75 riyals and receive USD1.00 in the future.

If the currency peg is removed and the currency depreciates to say 5 riyals, then I’ll make a lot of money.

How?

Well, when my contract expires I can go into the currency market, pay USD1.00 and get 5.00 riyals.

And then, to settle my forward contract, I only need to pay 3.75 riyals to get the same dollar back in my forward contract.*

*Note: the contract actually settles without having to go through this convoluted process but I wanted to explain the economics of the transaction.

And the best part? If the peg holds and the currency ends up at 3.75 then my downside is practically nothing!

This leads me to the second main way to bet against a currency… the FX options market.

In an FX option, I pay an upfront premium for the right to sell riyals and receive dollars at the specified exchange rate (my ‘strike’ rate) in the future.

The key difference here between the FX forward and the FX option is downside risk.

Let me explain.

In the currency forward, what happens if the riyal is de-pegged BUT instead of depreciating against the dollar, it gets stronger?

I’d lose money.

And in fact there’s a lot of potential downside there.

What if the USDSAR rate strengthened to 3.0 or 2.0… that would hurt.

With the FX option, I pay my premium upfront.

This is my maximum downside amount.

When the option expires, if the USDSAR is greater than my pre-picked ‘strike’ rate of say 3.75 then I’ll get paid out.

The higher above my strike rate (i.e. the more the riyal depreciates), the more money I make!

When pricing options, there are a few key inputs:

  1. The current exchange rate
  2. The strike price
  3. Maturity
  4. The forward price
  5. Volatility

But just a quick word on volatility…

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In a fixed currency regime, currency volatility is very low. This should be obvious.

The currency is pegged! It’s not allowed to move around much.

So if currency volatility is low, then from an option pricing perspective it implies my bet is unlikely to pay off.

Therefore the option is cheap.

What this all boils down to is this: it is extremely cheap to bet against currency pegs AND you can get paid off big time if your timing is right.

And the world loves cheap bets…

~

[Peter] Not surprisingly, pegged currencies are coming under fire right now.

The chart below shows the 12-month forward currency rates for the Hong Kong dollar and Saudi riyal.

You can see that from the middle of 2015, traders started betting against the riyal. The forward rate started moving up. It’s now at around 3.85.

This may not sound like much BUT it’s huge when you consider that in nearly 30 years the currency hasn’t closed weaker than 3.77.

Speculators reckon the collapse in oil prices will force the Saudi to devalue their currency.

Hong Kong Dollar (HKD) & Saudi Riyal (SAR) 12 month currency forwards from January 2014-2016. HKD per USD measured on the left hand side of the chart, with SAR per USD measured on the right hand side of the chart.

Turning now to the Hong Kong dollar.

Since the start of the year the turmoil in China’s stock market and renminbi is causing a wave of speculation that Hong Kong will abandon its peg.

(The Hong Kong Monetary Authority (HKMA) maintains the Hong Kong dollar in a convertibility band of 7.75-7.85 per U.S. dollar.)

In the chart above you can see that the 12-month HKD forward rate is now trading above the higher end of the convertibility band of 7.85.

Speculators are betting heavily that Hong Kong will be forced to abandon the peg.

CNN asked me earlier this week to come in and comment on this.

I’m out of town at the moment. So let me tell you what I would have told them.

I don’t buy it.

We have seen periodic bouts of pressure on the Hong Kong dollar. In fact, since the GFC we’ve seen the HKD trade at the strong side of the band.

In late 2011 you might remember that big swinging hedge fund manager Bill Ackman made a big bet on a de-peg of the Hong Kong dollar.

You can see all 140 slides of his presentation explaining his rationale by clicking here. At the time he was betting on a stronger Hong Kong dollar.

(Remember the difference between FX forwards and options? Right now the Hong Kong de-peg trade is going in completely the other direction as Mr. Ackman suggested.)

This is just another round of speculation that won’t payoff. Why? Because the HKMA can comfortably defend the peg.

Let me explain.

Hong Kong’s monetary base represents the total amount of money (HKD) in terms of all public and bank vault cash plus bank reserves maintained with the central bank.*

*Note it’s not quite the same as money supply which is public cash plus general bank deposits.

Right now, Hong Kong’s monetary base is just under HKD1.6 trillion. This is roughly USD205 billion.

The HKMA (Hong Kong’s defacto central bank) like any central bank, holds foreign reserves. These reserves consist of foreign currency, foreign bonds, gold, and SDR’s for example.

When people want to buy Hong Kong dollars, the HKMA issues HKD and takes foreign currency.

Take a look at the chart below. For most of the 2000’s, the level of reserves and monetary base remained pretty stable.

Hong Kong Monetary Base and Foreign Reserves since January 2002, showing US$155 billion in surplus reserves by January 2016.

However, when the GFC hit, there was a rush to buy Hong Kong dollars because they represented safety and stability.

But the key here is the reserves available to the HKMA…

Hong Kong’s entire monetary base is completely backed by foreign reserves. And there’s nearly USD155 billion of extra reserves available to defend the peg.

At this point the pressure on the peg is not huge. It’s way less than back in 1998.

At that time there was fear in the eyes of anyone investing or running businesses in Asia.

Hong Kong’s peg was the only currency that stood firm in the entire Asian region. Every other currency floated and promptly fell by anywhere from 25% to 85% in the case of Indonesia.

The Hong Kong dollar survived massive devaluations of all of its neighbours.

Given the regional currency crisis, which was orders of magnitude greater than the present Asian currency imbroglio, it was only natural that we would see pressure on the Hong Kong dollar peg.

I recall vividly, it was a tough time.

The favoured trade was using Hong Kong’s market like an ATM.

With a simple combination of trades in the currency and the stock market, hedge funds and other savvy local investors were literally able to “print” money.

The stock market was being shorted to hell alongside a gigantic bet that the currency would be de-pegged and crumble.

It had been a winning combination in other regional markets.

Fear was palpable.

In the midst of this I was attending a cocktail party at the house of the Indian Consul General on the peak in Hong Kong. A couple of stiff gin and tonics went down well!

During the event we got word that the Hong Kong government, via the HKMA, had initiated a massive buy program in the local stock market.

Officials planned to sell down foreign exchange reserves and buy more than 10% of the Hang Seng index.

This immediately sent all the short sellers into a frenzy of short covering (i.e. buying back shares).

They were getting creamed by the government-initiated rally. Their short covering boosted the market further.

From mid-August 1998 when the HKMA started buying to the end of November, the Hang Seng rallied over 60%.

At the time I remember a lot of die hard old school investment bankers – my regional boss amongst them – decrying the government intervention in the market.

As a fervent free market person myself I had some sympathy for their outcry.

On reflection I came to think that the government position was justified.

The credibility of the market and the currency was, and still is of paramount importance to Hong Kong as one of a small crop of globally important financial centres.

If it loses credibility in its open market, its currency, it will court financial suicide.

The short sellers left the playing field badly bruised and order was restored.

That huge pile of stocks acquired by the Monetary Authority was ultimately placed in a Fund that is still traded today and is a very successful vehicle for investors wanting quick, easy, cheap access to this market.

It sits happily in a great many pension fund accounts (although possibly not so happily at the moment).

So far, at least, the pressure on the peg is nowhere near as invidious as it was back then in 1998.

And you can rest assured that the authorities have the resources and inclination to defend this peg if the pressure builds.

The peg is the bedrock of Hong Kong’s financial stability.

If and when this peg is removed, it will not be done in the midst of a crisis. It’ll be done with zero warning on a quiet afternoon when markets are calm and nobody is paying attention.

If you are looking to make currency bets there are easier fish to fry than the Hong Kong dollar.

Good investing,

Peter Churchouse

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