How Credible is Hong Kong's Currency Peg?

Abstract

In this paper, we develop an asset-pricing model for the Hong Kong dollar (HKD) exchange rate. The model assumes that the HKD-USD peg is not fully credible, and financial markets assign a nonzero probability to its breakdown. We derive an analytical formula for model-implied option prices and use HKD options to estimate the model. Our estimation results suggest that financial markets perceive an increased risk of the peg breaking, driven by recent U.S. interest rate hikes and Hong Kong's slowing economy.

Keywords: Hong Kong dollar, HKD, currency board, peg, central parity, credibility