Foreign Exchange and Currency Markets
This domain is compact but highly testable: the Linked Exchange Rate System, the currency-board mechanics behind it, and forward pricing by covered interest parity. Most marks are lost on direction, not on theory.
The Linked Exchange Rate System
Since 1983 the HKD has traded against the USD, and since 2005 within a band of 7.75 (strong side) to 7.85 (weak side). The HKMA runs a currency-board-style system: the monetary base is backed by USD reserves at 7.80. When the market rate reaches 7.75, the HKMA sells HKD and buys USD, the Aggregate Balance expands and HIBOR falls. At 7.85 the HKMA buys HKD, the Aggregate Balance contracts and HIBOR rises. Interest rates, not the exchange rate, absorb the adjustment - that is the design.
The Discount Window lets banks borrow HKD against Exchange Fund paper at the HKMA Base Rate, set at the higher of the upper bound of the US federal funds target range plus 50bp, or the average of overnight and 1-month HIBOR.
Spot, forward and swap points
HKD/USD spot settles T+2. Forwards are derived from spot and the interest differential, via covered interest parity:
F = S × (1 + i_quote) ÷ (1 + i_base).
Worked example. Spot USD/HKD = 7.8000, HKD 1-year rate 4.00%, USD 1-year rate 5.00%. F = 7.8000 × (1.04 ÷ 1.05) = 7.7257. The lower-yielding currency (USD) trades at a forward discount of roughly 744 points. An exporter selling USD forward locks in 7.7257 and gives up the higher USD interest - that forgone interest is the cost of the hedge, not an arbitrage.
CNY and CNH
Onshore CNY and offshore CNH trade as separate markets. CNH is freely deliverable offshore, so the two can diverge when capital-flow pressure builds. Settlement risk of the Herstatt type is why CLS exists for major currency pairs.
Traps
- Inverting the parity formula so the low-yielding currency appears at a forward premium.
- Mixing up the sides: at 7.75 the HKMA sells HKD, it does not buy.
- Quoting USD/HKD and HKD/USD interchangeably in a calculation.
- Treating a forward rate as a forecast rather than an interest-rate-derived price.