What is the rationale of the double-play strategy, Financial Management

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Q. What is the rationale of the double-play strategy?

Hedge Fund enters agreement to sell HK$ in six month's. At expiration the Hedge Fund requires to buy spot HKD and deliver these against the short future's position.

If the peg embraces the cost of replacing the HKD it has sold is fundamentally the 6 month differential between USD and HKD interest rates.

On Thursday August 20th the dissimilarity in inter-bank interest rates was about 6.3% Hong Kong rates being higher due to heavy demand for HKD loans which are needed to short the currency. Consequently a hedge fund manager making a USD 1 million bet Thursday against the HKD would have paid USD63000.

If the finance manager believed that the peg would break and thus the HKD depreciate say about 30% then the potential profit would be USD300000. Evaluated to the cost of making the trade USD63000 this is a good profit.

MA Intervenes HKMA interfere to defend the peg. Utilize its own FX reserves MA sold USD. Usually when a country with a pegged currency spends reserves to defend the currency's value the intervention will have to be sterilized. In other sense the central bank would purchase local currency bonds from the banking system. The purchase will be roughly in alike quantities so that the overall monetary base remains constant.

Nevertheless doing this in Hong Kong at that time would result in further increases in interest rates. This would be considered as harshly harmful by real estate companies in Hong Kong.

What is the rationale of the double-play strategy?

The hedge funds deploy a double-play strategy in order to engineer steep increases in interest rates and steep declines in stock prices so as to gain from their short positions in the stock market and in the FX futures market.

However first some comments about the economic conditions prevailing at that time. In untimely August of 1998 external and domestic conditions deteriorated. The Dow Jones index refuse sharply by 300 points on August 5th and the Yen was at an eight year low at 147 on August 11th. Rumours were plentiful concerning abandonment of the peg. There was powerful selling pressure on HKD early August.

1. Entrepreneurs shorted the HKD by swapping HKD for USD.

2. On the equity markets the stocks index futures market open positions grow brusquely

The HSI FUTURES rise from 70000 contracts in June to 92000 contracts in August. The strategy of the Hedge Funds was to weaken the steadiness of the exchange value of the HK$ consequently as to produce sharply higher interest rates.

The sharp raise would then lower stock prices it was hoped. Hedge Funds sell HKD. This raise HKD interest rates(r). Such high interest rates can't be tolerated by property developers. Real Estate companies undergo serious losses and their stocks decline sharply. The HSI goes down as the HIBOR goes up. At this point one more strategy is to short sell borrowed shares. So far the existence of futures markets makes this redundant. A speculator is able to short the HSI index instead.


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