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The Hong Kong Dollar and the Carry Trade

Mar 08, 2018

In in the early years of equity and foreign exchange trading, arbitrage was an effective investment strategy since it capitalized on a communication system that was not properly interconnected. Arbitrage in established markets has largely been eliminated through the adoption of technology which has allowed for instantaneous exchanges of data.  As Karen Yeung posits in her article “What ails the Hong Kong dollar? It is the carry trade” there are still circumstances in which, despite the currently high level of market connectivity, investors can take advantage of various arbitrage strategies. Carry trades are placing downward pressure on the value of the Hong Kong dollar as investors borrow at increasingly lower rates, and reinvest into the more lucrative U.S dollar.

The carry trade is a more basic form of arbitrage that does not require an advanced understanding of markets to execute. Simply put in this case, investors are borrowing the Hong Kong dollar, which offers a relatively low yield, and then selling this currency to buy higher yielding U.S dollars. The gap between the Hong Kong interbank offer rate (HIBOR) and the Intercontinental Exchange London interbank offered rate (LIBOR), which is used by the U.S, has expanded and is currently at its largest spread since 2008. A rising LIBOR typically indicates the potential for higher yields as the borrowing cost of banks rise, and they are willing to reward those with savings. Investors can borrow capital relatively inexpensively, and immediately use those funds to invest in the U.S dollar, thus capturing positive returns. While this appears to be a promising investment approach, it comes with a significant caveat.

As long as the HIBOR rate continues to hold or shift downward relative to the LIBOR, investors will find this strategy to be profitable. The potential drawback is the risk that rates shift and begin to move closer together. This would effectively eliminate much of the investment appeal of the strategy, and if rates were to inverse, it would create losses for the investor. This would certainly seem to an appealing approach currently, but as with any investment there are risks to consider.