DISLOCATIONS IN FX SWAP AND MONEY MARKETS IN HONG KONG AND POLICY ACTIONS DURING THE FINANCIAL CRISIS OF 2008

Transcription

1 Working Paper 7/009 3 Ocober 009 DISLOCATIONS IN FX SWAP AND MONEY MARKETS IN HONG KONG AND POLICY ACTIONS DURING THE FINANCIAL CRISIS OF 008 Prepared by Laurence Fung and Ip-wing Yu Research Deparmen Absrac When US dollar inerbank markes malfuncioned during he global financial crisis of 008, many non-us financial insiuions relied heavily on he foreign-exchange (FX) swap markes for US-dollar funds. This one-sided marke induced a risk premium of he FX swap-implied US-dollar rae across a range of funding currencies, i.e. a deviaion from he covered ineres pariy (CIP) condiion. The urbulence in he global inerbank markes herefore spilled over o he FX swap markes, including ha in Hong Kong. This paper analyses he effeciveness of he policy acions aken by he Hong Kong Moneary Auhoriy and he Governmen in responding o he dislocaions and sress in he local inerbank and FX swap markes. Our resuls show ha he policy acions effecively amelioraed he FX swap marke dislocaions afer he failure of Lehman Brohers, i.e. reducing he CIP deviaions. JEL Classificaion Numbers: F3, G4, G5 Keywords: FX swaps; Covered ineres pariy; inerbank sress; Exponenial GARCH Auhors Addresses: Laurence_KP_Fung@hkma.gov.hk; Ip-wing_Yu@hkma.gov.hk The views and analysis expressed in his paper are hose of he auhors, and do no necessarily represen he views of he Hong Kong Moneary Auhoriy. The auhors are graeful o Dong He and Cho-hoi Hui for heir useful commens.

2 - - Execuive Summary: When US-dollar inerbank markes malfuncioned during he recen financial crisis, many non-us financial insiuions relied heavily on FX swap markes o raise US dollars using local currencies. This one-sided marke induced a risk premium of he FX swap-implied US dollar rae (across a range of funding currencies) ha he non-us financial insiuions had o pay over he corresponding dollar LIBOR rae, i.e. a deviaion from he covered ineres pariy (CIP) condiion. This unusual pricing behaviour refleced dislocaions in he FX swap markes. The urbulence in he global inerbank markes herefore spilled over o he FX swap markes, including ha in Hong Kong. This paper analyses he effeciveness of he policy acions aken by he Hong Kong Moneary Auhoriy and he Governmen in responding o he dislocaions and sress in he local inerbank and FX swap markes. We find ha he policy acions effecively amelioraed he FX swap marke dislocaions afer he failure of Lehman Brohers, i.e. reducing he CIP deviaions in he local financial markes. This indicaes ha he policy acions improved he efficiency of he inerbank and FX swap markes in which marke liquidiy resumed o eliminae arbirage opporuniies. The adverse impac of inerbank credi marke ensions on he local financial markes was hus miigaed during he global financial urmoil. In paricular, he five emporary measures provided addiional longer-erm funding o banks agains a wider range of collaeral a a poenially lower ineres rae cos. Banks were more assured abou he availabiliy of funds, and more willing o lend in he inerbank marke. Furhermore, policy acions aimed a conaining he solvency risk in he banking sysem relaxed he counerpary-risk consrain in he markes and hus removed he financial dislocaions.

3 - 3 - I. INTRODUCTION The sub-prime crisis emerged in he Unied Saes in mid-007 and spilled over o oher economies. From mid-007 o mid-008, he spillovers were relaively modes. The siuaion began o change in mid-008. Following he bankrupcy of Lehman Brohers in mid-sepember 008, developmens ook a dramaic urn. One channel for spillovers was severe disrupions in inernaional money markes. Uncerainy abou losses incurred in banks increased heir liquidiy needs as well as heir relucance o lend o each oher in money markes. Reflecing hese and possibly oher facors, inerbank shor-erm ineres raes surged subsanially afer he Lehman failure, and hen persised a high levels, promping cenral banks around he world o adop unprecedened policy measures o supply funds o he banks. The Hong Kong Moneary Auhoriy (HKMA) and he Governmen also announced a series of measures o help conain he global risks from spilling over o he domesic banking sysem. In his paper, we conduc an even sudy o examine he effeciveness of he various policy acions aken by he HKMA and he Governmen in apprehending he anomalies and disress in he local financial markes, especially afer he Lehman failure in mid-sepember 008. We invesigae how hese measures miigaed he adverse impac of he urbulence in he global inerbank markes on he local inerbank marke and foreign exchange (FX) swap marke. II. DISLOCATION IN THE FX SWAP MARKET AND THE STRESS IN THE HONG KONG DOLLAR INTERBANK MARKET A FX swap is a conrac in which wo paries agree o borrow and lend wo currencies by enering ino FX spo and forward conracs. For insance, a financial insiuion in Hong Kong, when in need of US-dollar (USD) funds, can eiher (i) borrow direcly in he USD uncollaeralised cash markes or (ii) borrow in he Hong Kong-dollar (HKD) uncollaeralised cash marke and conver he HKD proceeds ino USD a he FX spo rae while conracing o exchange in he reverse direcion a mauriy a he FX forward rae. Char provides a simple illusraion of he cash flows in a HKD/USD FX swap ransacion. While we use a financial insiuion as an example, oher eniies such as exporers and imporers, as well as insiuional invesors also employ FX swaps o fund heir foreign-currency needs or o hedge heir posiions agains he FX risk.

4 - 4 - Char. Cash flows in a FX swap ransacion A iniiaion of he FX swap conrac ( = 0) Bank A S unis of HKD Bank B uni of USD S = spo exchange rae (HKD/USD) A mauriy of he FX swap conrac ( = T) F unis of HKD Bank A Bank B F = forward exchange rae (HKD/USD) uni of USD When uncollaeralised USD money markes malfuncioned and he inerbank ineres raes sho up during he urmoil, many non-us financial insiuions relied heavily on FX swap markes o raise USD using local currencies. FX swap-marke premiums rose, as many non-us financial insiuions found hemselves facing similar USD funding shorages. Heighened concerns over liquidiy and counerpary risk raioned hem ou of he USD money marke, and hey all bid for USD in he FX swap marke, creaing a one-sided marke. From he beginning of he financial urmoil in Augus 007, here emerged a risk premium of he FX swap-implied USD rae (across a range of funding currencies) ha he non-us financial insiuions had o pay over he corresponding USD LIBOR rae, while such risk premium had normally been close o zero. This unusual pricing behaviour refleced dislocaions in he FX swap marke. I is a well-esablished and well-esed heory in inernaional finance ha he reurn of invesing a sum of money in a domesic ineres-bearing asse for a cerain period of ime is he same as he reurn of invesing in a similar foreign ineres-bearing asse by convering he sum ino a foreign currency while simulaneously purchasing a fuures conrac o conver he invesmen back a he end of he period. If he reurns are differen, an arbirage ransacion could, in heory, produce a risk-free reurn. This condiion is commonly known as he covered ineres pariy (CIP) condiion. The CIP condiion holds if he inerbank and FX swap markes funcion normally and efficienly.

5 - 5 - The CIP condiion is observed almos all he ime. However, here are imes and siuaions in which he condiion breaks down. 3 One possibiliy is ha in imes of financial urmoil he risks as perceived by marke paricipans migh change, rendering he assumpions of he CIP condiion inapplicable. Indeed, Baba and Packer (008) and Genberg e al. (009) find ha in he recen global financial crisis he urbulence in money markes spilled over o FX swap markes amid a reappraisal of counerpary risks. During he financial crisis, he urbulence in he global inerbank markes spilled over o he local financial markes in which deviaions from he CIP condiion were observed in erms of he difference beween he FX swap-implied USD rae and he USD LIBOR as shown in he following equaion: HKD USD ( + r ) ( r ) F, + x CIP deviaion =, x +, x S 443 () USD in erbank rae FX swap implied USD rae where S is he HKD per USD spo rae a ime. F + x forward rae conraced a ime for exchange a ime + x., is he HKD per USD HKD x r, and USD x r, are he corresponding uncollaeralised HKD and USD ineres raes a ime wih a enor of x, proxied by he HKD inerbank rae (HIBOR) and he USD inerbank rae (LIBOR) respecively wih he same enor. In Char, he red line measures how much he FX swap implied hree-monh USD funding rae deviaes from he corresponding USD LIBOR he risk premium demanded by dollar lenders in he swap marke or he deparure from CIP in he local financial markes. As can be seen, before Summer 007 i oscillaed around 0 basis poins (bps) bu afer ha i sared o follow an upward rend. Around he beginning of Sepember 008, i flucuaed wildly. 3 See Taylor (989) for such occasions during he floaion of serling in 97 and he incepion of he European Moneary Sysem in 979.

6 - 6 - Char. FX swap-implied USD rae, USD LIBOR and CIP deviaion Ineres rae (% p.a.) Aug 07 Onse of crisis 4 Mar 08 Bear Searns acquired 5 Sep 08 Lehman failure Three-monh FX swap-implied USD rae CIP deviaion (in bps) 80 Deviaion from CIP (rhs) Three-monh USD LIBOR Jan-07 Apr-07 Jul-07 Oc-07 Jan-08 Apr-08 Jul-08 Oc-08 Jan-09 Apr-09 Sources: Bloomberg and HKMA saff esimaes. In addiion o he dislocaions in he local FX swap marke refleced by he CIP deviaions, he HKD inerbank marke was also under sress during he crisis. We use he spread of he hree-monh HIBOR relaive o he hree-monh overnigh index swap (OIS) rae as a measure of sress in he local inerbank marke. 4 Char 3 shows ha he hree-monh HIBOR OIS spread increased when he crisis emerged in Augus 007 and surged o more han 00 bps afer he Lehman failure. This sudy uses he CIP deviaion and he HIBOR OIS spread as measures o assess wheher he policy acions aken by he HKMA and he Governmen improved marke efficiency and reduced he sress on he local financial markes. 4 An OIS is an ineres-rae swap in which he floaing leg is linked o a published index of daily overnigh raes. The wo paries agree o exchange a mauriy, on an agreed noional amoun, he difference beween ineres accrued a he agreed fixed rae and ineres accrued hrough he geomeric average of he floaing index rae. Since he overnigh ineres raes generally bear lower counerpary and liquidiy risks, he credi and liquidiy risk premiums conained in he OIS raes should be small. Therefore, he hree-monh HIBOR OIS spread generally reflecs he counerpary and liquidiy risks in he inerbank marke.

7 Char 3. 3-monh HIBOR - OIS spread (in bps) Three-monh HIBOR OIS spread 3-monh HIBOR - OIS spread (in bps) Sep 08 Lehman failure Aug 07 Onse of crisis 4 Mar 08 Bear Searns acquired Jan-07 Apr-07 Jul-07 Oc-07 Jan-08 Apr-08 Jul-08 Oc-08 Jan-09 Apr-09 Sources: Bloomberg and HKMA saff esimaes. III. KEY POLICY ACTIONS AND ANALYSIS FRAMEWORK In response o he sress in he HKD inerbank marke following he Lehman failure in mid-sepember 008, he HKMA and he Governmen announced a series of emporary measures o help conain he liquidiy and solvency risks in he domesic banking sysem. Table presens he policy iniiaives since Sepember If hese policy acions were effecive, hey should be able o alleviae he dislocaions in he FX swap marke and reduce he CIP deviaions Refer o HKMA (008) for more deails on measures underaken by he HKMA and he Governmen in response o he global financial crisis. The policy measures helped reduce counerpary credi risk concerns, ensured he availabiliy of backsop liquidiy and increased banks willingness o lend in he inerbank marke. These acions are expeced o eliminae arbirage opporuniies as marke liquidiy resumes o normalcy.

8 - 8 - Table. Policy measures underaken by he HKMA and he Governmen from Sepember 008 o March 009 Announcemen dae Measures 008 () 30 Sepember Five emporary liquidiy measures () 8 Ocober Modificaion of he Base Rae formula (3) 4 Ocober Two precauionary measures o suppor confidence in he Hong Kong banking sysem (4) 0 Ocober Addiional supply of hree-monh Exchange Fund Bills (5) 6 November Two refinemens o he emporary liquidiy measures (6) 4 November Addiional supply of hree-monh Exchange Fund Bills 009 (7) 6 March HKMA o coninue he provision of liquidiy assisance o banks Sources: HKMA (008) and HKMA press releases. In his sudy, we analyse (a) he CIP deviaion based on he difference beween he hree-monh FX swap-implied USD rae and LIBOR and (b) he inerbank marke sress in HKD measured by he HIBOR OIS spread. Our sample covers he period from 6 Sepember 008 o 3 March 009, which is he period immediaely afer he Lehman failure when he policy acions announced and ook place. The sample ends on 3 March 009 since by ha ime he hree-monh CIP deviaion had already vanished. Table repors he uni roo es resuls of he dependen variables under he sample period. Table. Augmen Dickey-Fuller (ADF) Uni Roo Tes Resuls In he level In he firs difference CIP deviaion * Three-monh HIBOR OIS spread * Noe: * indicaes significance a he 5% confidence level. The criical value a he 5% level of he ADF es is.883. The ADF ess sugges ha all he series are nonsaionary in he level bu hey are saionary in he firs difference. Therefore, he empirical analysis is based on he daily changes in hese series. Given ha he policy acions may influence boh he level and volailiy of he CIP deviaions and hree-monh HIBOR OIS spread, we follow Genberg e al. (009) o model he effec of policy acions under a sandard exponenial GARCH (EGARCH) model proposed by Nelson (99). The EGARCH model has been widely used in analysing he effecs of policy evens on financial markes,

9 - 9 - as he model capures he asymmeric effec in he volailiy of financial ime series. 7 A policy-acion dummy variable is used in he analysis, where he variable is equal o one on he days wih policy acions / announcemens and zero on oher days. In he EGARCH framework, he dislocaions in he HKD-USD FX swap marke, measured by he changes in he CIP deviaions, are assumed o be associaed wih he relaive risk of he banking sysems of Hong Kong and he US, along wih he policy-acion dummy. 8 The policy-acion dummy is also pu ino he condiional variance equaion o sudy wheher i has any effecs on he degree of volailiy. The condiional mean equaion of he EGARCH model is wrien as: n CIP = a + bi CIP i + c RRB + d PA + CIP,, CIP, ~ N(0, σ ) () CIP, where is he firs-difference operaor. CIP is he CIP deviaion (in bps) a ime for he respecive crisis period. RRB is he variable for he relaive risk of he banking sysems of Hong Kong and he US a ime, which is measured by he difference (in bps) beween he HIBOR OIS spread and he USD LIBOR OIS spread during he global credi crisis of 008. PA is he dummy variable for policy acion announcemen a ime. Lags of he dependen variable are included in Equaion () o conrol for he serial correlaion, if necessary. As discussed in Genberg e al. (009), if he relaive risk of he banking sysems is a deerminan of he premium or discoun as refleced in he swap-implied USD rae, he esimaed coefficien c in Equaion () should be posiive and saisically significan. If he policy acions are helpful in reducing he CIP deviaions, he esimaed coefficien d should be negaive (and i should also be saisically significan if he policy acions have a maerial impac on he CIP deviaions). given as: In he EGARCH (p, q, r) model, he condiional variance equaion is ln( σ + ϑpa (3) q p r CIP, i CIP, k CIP, ) = ϖ + β j ln( σcip, j ) + α i + γ k j= σcip, i k = σcip, k The coefficien ϑ measures he poenial impac of he policy acions on he degree of volailiy. If he policy acions have he desirable effec of reducing he volailiy of he CIP deviaion, he esimaed coefficien ϑ is expeced o have a negaive sign. 7 8 Primarily, he EGARCH model capures he idea ha bad news (negaive shocks) ends o have a greaer impac on he condiional volailiy han good news (posiive shocks) of he same magniude. The relaive risk of he banking sysem can be considered as he funding liquidiy risk, see Hui e al. (009).

10 - 0 - The coefficien β measures he persisence effec in he dynamics of he condiional variance σ, while he coefficien γ k capures he asymmeric effec of news. A similar framework is applied o analysing he relaionship beween he inerbank sress measured by he HIBOR-OIS spread and he effeciveness of he policy acions. Fung and Yu (009) find ha during he credi crisis of 008, he disress in he USD inerbank marke had a maerial impac on he HKD inerbank marke. Thus, in he condiional mean equaion of he EGARCH model, he inerbank-sress indicaor for he HKD is assumed o have a linear relaionship wih he sress measure of he USD inerbank marke. The condiional mean equaion is specified as: HK n HK HK US bi IS i + cis + d IS + epa + IS, IS = a +, ~ N(0, σ ) (4) where is he firs-difference operaor. HK IS and US IS are he inerbank-sress indicaors for HKD and USD (in bps) respecively a ime, which are he HIBOR OIS spread and USD LIBOR OIS spread. The lagged erm of he HKD inerbank-sress HK indicaor ( IS ) is included as a conrol variable in case he changes of he spread depend on is level. 9 PA is he dummy variable for policy-acion announcemen a ime. Lags of he dependen variable are included in Equaion (4) o conrol for he serial correlaion, if necessary. If policy acions can ease he disress in he HKD inerbank marke, hen i is expeced ha he esimaed coefficien e should be negaive (and should also be saisically differen from zero if he policy acions have a maerial impac on he inerbank-sress indicaor). given as: Similarly, he condiional variance equaion in he EGARCH model is ln( σ + ϑpa (5) q p r i k ) = ϖ + β j ln( σ j ) + αi + γ k j= σ i k= σ k The coefficien ϑ measures he poenial impac of policy acions on he degree of volailiy. Again, if policy acions have any effec on reducing he volailiy of he HIBOR OIS spread, hen he esimaed coefficien ϑ is expeced o have a negaive sign. 9 The inclusion of he lagged erm of he spread as a conrol variable is similar o McAndrews e al. (008) in heir analysis of he relaionship beween he change in he USD LIBOR-OIS spread and he Term Aucion Faciliy announced by he Federal Reserve.

11 - - IV ESTIMATION RESULTS Table 3 repors he EGARCH esimaion resuls of he CIP deviaion, he HIBOR OIS spread and he effeciveness of he policy acions for he global credi crisis of 008. Table 3. Esimaion resuls on he CIP deviaion, HIBOR OIS spread and he effeciveness of policy acions for he global credi crisis of 008 \ Sample period: 6 Sepember 008 o 3 March 009 Dependen variable: Changes in CIP deviaion ( CIP ) Dependen variable: Changes in HIBOR OIS spread ( IS ) Esimaed coefficien in he condiional mean equaion n n HK HK HK US CIP = a + bi CIP i + c RRB + d PA + IS CIP, = a + bi IS i + cis + d IS + epa + a 0.0 (0.84) b 0.08 (.5) c 0.* (5.) PA (d).0** (.86) ln( σ a 5.4 (.94) b c 0.08* (.04) d 0.3* (.) PA (e) 3.67 (0.33) Esimaed coefficien in he condiional variance equaion q p r CIP, i CIP, k CIP, ) = ϖ + β j ln( σcip, j ) + αi + γ k j= σcip, i k = σcip, k + ϑpa ln( σ q p r i k ) = ϖ + β j ln( σ j ) + α i + γ k j= σ i k = σ k + ϑpa ϖ 0.4 (0.84) β 0.98* (65.3) α 0.7 ( 0.86) γ 0.0 ( 0.34) PA ( ϑ) 0.7 (.0) ϖ 0. (.0) β 0.99* (68.46) α 0.9* (.07) γ 0.0 ( 0.05) PA ( ϑ) 0.33 (0.36) Noe: Source: Figures in parenheses are z-saisics based on Bollerslev-Wooldrige robus sandard errors. * indicaes significance a he 5% confidence level. ** indicaes significance a he 0% confidence level. HKMA saff esimaes.

12 - - The resuls show ha he policy acions have a negaive impac (wih saisical significance) on he CIP deviaions, suggesing ha he policy acions effecively reduced he CIP deviaions during he crisis. This implies ha arbirage opporuniies diminished as he financial markes reurned o normal o a cerain exen. In oher words, following he Lehman failure he policy acions aken by he HKMA and he Governmen helped miigae he dislocaions and herefore improved he efficiency in he money and FX swap markes o faciliae arbirage ransacions. In paricular, he five emporary measures provided addiional longer-erm funding o banks agains a wider range of collaeral a a poenially lower ineres cos. Banks were more assured abou he availabiliy of funds, and more willing o lend in he inerbank marke. Furhermore, policy acions aimed a conaining he solvency risk in he banking sysem relaxed he counerpary-risk consrain in he markes and hus removed he financial dislocaions. Regarding he resuls on he hree-monh HIBOR OIS spread (he indicaor of sress in he inerbank marke), he policy acions had no maerial impac on he spread, indicaing ha hey did no ease he disress in he longer end of he HKD inerbank marke afer he Lehman failure. 0 This finding is however consisen wih he recen sudy by he IMF (009) which shows ha he liquidiy suppor measures iniiaed by he cenral banks in Japan, Sweden, Swizerland, he Unied Kingdom, he Unied Saes and he European Cenral Bank had an insignifican impac on he LIBOR OIS spreads afer he Lehman failure. The IMF sudy suggess ha he finding does no necessarily mean ha he policy acions on providing liquidiy o he banking sysem were no effecive, bu he acions may have been anicipaed by marke paricipans. Therefore, heir effecs on he LIBOR-OIS spreads are no noiceable in he empirical ess. The same marke reacions migh also happen in Hong Kong, causing he effecs of he policy acions by he HKMA and he Governmen on he HIBOR OIS spread no o be visible in our empirical analysis. V. CONCLUSION This sudy invesigaes he effeciveness of he policy acions aken by he HKMA and he Governmen o miigae he anomalies and sress in he FX swap and inerbank markes in Hong Kong during he financial crisis of 008. The resuls sugges ha he policy acions effecively reduced he dislocaions in he FX swap marke afer he Lehman failure. The reducion in he CIP deviaions refleced ha he policy acions improved he efficiency of he money and FX swap markes in which marke liquidiy resumed o eliminae arbirage opporuniies. 0 Shorly afer he measures were implemened, he overnigh HIBOR gradually eased.

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