Risk premium, currency board, and attacks on the Hong Kong dollar

Abstract

Hong Kong’s “linked exchange rate ” (also known as the “peg”) is a currency board system under which the Hong Kong dollar notes are fully backed by the U.S. dollar at the rate of HK$7.8 per US dollar. In this paper we present an event analysis of the credibility of the peg as measured by the forward premium recovered from forward exchange rates. Based on the forward premium from January 1997 to December1998, the devaluation probability of the Hong Kong dollar as perceived by the foreign exchange market is calculated. We examine the evolution of credibility during this period using the theoretical framework of a target zone model. The relationship between Hong Kong dollar’s risk premium during the recent Asian financial crisis and four fundamental economic variables whose deterioration is widely regarded as conducive to currency crisis is explored.