THE SWAP MARKET
The swap market in Hong Kong plays an important role in channelling funds. It
is also a highly efficient indicator of confidence in the linked exchange rate.
Readers who are familiar with the foreign exchange and money markets, and
have been monitoring developments there, will have noticed that the so-called
“swap” prices have recently changed quite a lot. For swaps of up to one-year
duration, the prices have been trading near zero, and fluctuating within a
narrow range from a 5 to 75-pip premium. At the height of the financial
turmoil at the end of August 1998, the one-year swap, for example, was traded
at a premium of 6,800 pips; the three-month swap was at a premium of around
1,900 pips.
(See chart)
Notwithstanding the technical complexities
surrounding the dynamics of the swap market, the trends in this market do
contain meaningful underlying messages that I think should be of interest to the
general public. Allow me to be somewhat didactic this week in offering a
layperson’s guide on the swap market.
Let me first explain what a swap is. It is an arrangement whereby one currency
is exchanged for another currency for a defined period. This is to facilitate
whoever is in possession of one of the two currencies, and has a temporary
need for the other currency, to manage the exchange risk by crystallising it upfront to avoid the uncertainties of subsequent exchange rate movements. Thus
if you hold US dollars and you have a temporary need for Hong Kong dollars
for, say, three months, and you want to be protected against unexpected
exchange rate movements, you can do a three-month swap. It is like borrowing
Hong Kong dollars for three months on the security of US dollars. But what
actually happens is that you sell your US dollars now at the market exchange
rate, and at the same time enter into a contract to buy them back in three
months’ time at an exchange rate adjusted by the three-month swap price. The
swap price is expressed in terms of the differential in the exchange rates of the
Hong Kong dollar against the US dollar when the swap is made (spot) and
when the swap is reversed (forward), with one cent being 100 swap pips. It can
be at a premium or a discount.
The price of the swap bears a fairly mechanical relationship to the interest rate
differential between the two currencies, although the money raised through the
swap is not necessarily held as deposits earning interest. If the three-month
interest rate for the Hong Kong dollar is higher than that for the US dollar, then
whoever, through the swap, is temporarily holding Hong Kong dollars for three
months will earn a higher return than the counterparty temporarily holding US
dollars. This will be reflected in the swap price in the form of a premium,
meaning that, in three months’ time, you will need more Hong Kong dollars to
buy back the US dollars that you have just sold. Similarly, a swap price
showing a discount would reflect Hong Kong dollar interest rates being below
those of the US dollar. And a price around zero means that Hong Kong dollar
interest rates are about the same as US dollar interest rates.
The swap price may seem, to the layperson, to be a rather convoluted way for
the market to be making comparisons between the interest rates for the two
currencies. But, for market participants, it is a highly efficient indicator that
brings together the forces of the inter-related wholesale deposit and foreign
exchange markets involving the two currencies. Traditionally, the swap market
is where licensed banks with no Hong Kong dollar deposit base gain access to
Hong Kong dollar funding without having to be overly dependent upon the
Hong Kong dollar interbank market.
It is also a popular mechanism for
licensed banks with a substantial Hong Kong dollar deposit base to put excess
Hong Kong dollar liquidity to use without incurring too much credit risk
arising from otherwise lending funds directly in the interbank market. Over
time, the swap market has gained considerable sophistication and complexity,
with market plays developed for different swap periods to take advantage of
opportunities for profit, or market anomalies, as perceived by market
participants. It has become a very efficient market with a high degree of
liquidity. And with the Hong Kong dollar linked to the US dollar, the swap
prices of different swap periods have become reliable indicators of the flow of
funds into and out of the Hong Kong dollar, and also of the level of confidence
in our currency.
As a rule of thumb, the closer the swap price is to zero and the longer this
phenomenon is manifested in the maturity period of the swaps, the higher is
confidence in the linked exchange rate system. A premium in the swap price
indicates the market perception of the possibility of outflow from the Hong
Kong dollar, and a discount indicates the market perception of the possibility of
inflow, although no light is thrown on the rationale behind them. But small
deviations of, say, up to 100 pips for a three-month swap are not really very
significant, as sentiment in the relative attractiveness of financial and other
investments in Hong Kong and the US shifts in response to new information
continuously made available.
In any case, the current movement in the
exchange rate applicable to Convertibility Undertaking for the clearing balance
of the banking system of one pip a day back to 7.80 should have produced a
90-pip premium in three months’ time. The fact that the three-month swap
price has instead been down to a discount of about up to 50 pips in recent
weeks is perhaps an indication of some inflow. However, too large a premium
or discount should create arbitrage activities that limit further deviation.
The recent behaviour of the swap market suggests that confidence in the linked
exchange rate is the highest we have seen. It also suggests some inflow as the
performance of the economy and of financial markets improves, providing
higher rates of investment return in Hong Kong.
Joseph Yam
20 April 2000
HK$ Swap points (Aug 1998 - Mar 2000)
7500
6500
Swap points started
to ease after the
introduction of the
seven technical
measures
5500
pips
4500
Financial trouble of GITIC
and subsequent credit
downgrade of China
enterprises
3500
3 Month
Tension across Taiwan
Straits and rumours of
RMB devaluation
12 Month
2500
1500
500
-500
08/98
10/98
12/98
02/99
04/99
06/99
08/99
10/99
12/99
02/00