Deviation from Covered Interest Rate Parity in Hong Kong

DISSERTATION
(DEVIATION FROM COVERED
INTEREST RATE PARITY IN
HONGKONG)

TABLE OF CONTENTS
cHAPTER 1 INTRODUCTION................................................................................................1
CHAPTER 2 LITERATURE REVIEW AND THEORY.........................................................3
2.1 Literature Review.............................................................................................................3
2.1.1. Changes take places in the covered interest parity in Hong Kong...........................3
2.1.2 Factors that causes differences between swap rate and interest rate in Hong Kong. 5
2.1.3 To tests the validity of the covered interest parity in Hong-Kong.............................7
2.1.4 Impact of foreign exchange liquidity conditions of bank on Covered interest parity9
2.2 Theoretical framework...................................................................................................12
CHAPTER 3 DATA AND METHODS..................................................................................14
3.1 Research methodology...................................................................................................14
3.2 Research approach..........................................................................................................15
3.3 Research design..............................................................................................................15
3.4 Research method............................................................................................................17
3.5 Data collection................................................................................................................17
3.6 Ethical considerations.....................................................................................................17
CHAPTER 4 ANALYSIS AND RESULTS............................................................................18
4.1 Descriptive statistics.......................................................................................................18
4.2 USDHKD Interest rates analysis using regression.........................................................73
4.3 Spot exchange rates........................................................................................................77
4.5 Regression among spot exchange and USD and HKD values.......................................81
Vector Auto aggressive model..........................................................................................96
CHAPTER 5 DISCUSSION AND CONCLUSIONS.............................................................98
5.1 Summary.........................................................................................................................98
5.2 Theoretical implications.................................................................................................98
5.3 Practical implications.....................................................................................................99
5.4 Limitations of research...................................................................................................99
5.5 Reflections....................................................................................................................100
5.6 Conclusion....................................................................................................................101
REFERENCES.......................................................................................................................102

INDEX OF TABLES
Table 1 Currency prices of USD-HKD....................................................................................36
Table 2 Descriptive statistics of currency prices.....................................................................36
Table 3 Opening prices of USD and HKD...............................................................................54
Table 4 Descriptive statistics of opening prices of USD and HKD.........................................55
Table 5 Low prices...................................................................................................................64
Table 6 Descriptive statistics of low prices..............................................................................64
Table 7 % changes in prices....................................................................................................73
Table 8 Regression Statistics...................................................................................................74
Table 9 ANOVA........................................................................................................................74
Table 10 RESIDUAL OUTPUT...............................................................................................75
Table 11 PROBABILITY OUTPUT..........................................................................................76
Table 12 Residual Plot.............................................................................................................76
Table 13 Normal Probability plot............................................................................................77
Table 14 Spot Exchange rates..................................................................................................80
Table 15 Regression analysis...................................................................................................86
Table 16 Regression Statistics.................................................................................................86
Table 17 ANOVA......................................................................................................................86
Table 18 RESIDUAL OUTPUT...............................................................................................88
Table 19 PROBABILITY OUTPUT..........................................................................................90
Table 20 Residual Plot.............................................................................................................91
Table 21 Line Fit Plot.............................................................................................................92
Table 22 Normal Probability plot............................................................................................93
Table 23 Interest rates of USD and HKD................................................................................95
Table 24 SUMMARY OUTPUT...............................................................................................95
Table 25 ANOVA......................................................................................................................95
Table 26 Coefficient.................................................................................................................96
Table 27 RESIDUAL OUTPUT...............................................................................................97
Table 28 Residual Plot.............................................................................................................97
Table 29 Overnight swaps........................................................................................................97
Table 30 NDF 3 month swap rate............................................................................................98
Table 31 SUMMARY OUTPUT...............................................................................................98
Table 32 ANOVA......................................................................................................................98
Table 33 Coefficient.................................................................................................................98
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Table 34 RESIDUAL OUTPUT...............................................................................................98
CHAPTER 1 INTRODUCTION
Unique topic has selected for this research study that steals the attention of all the
technical or non-technical users. The users will get insights about market trends from this
study and to take enough benefit from this. Nowadays, the scope of the stock market and
forex trading has increased with time as everyone wants to earn higher profit by investing in
the forex market. The biggest reason behind the fewer investments in the forex trading is due
to lack of knowledge and awareness about this concept as no one knows about this concept in
detail due to which they can make investments decisions.
In increasing awareness among the people about this field, the researcher performs
this research study to explore the hidden or known aspects of the covered interest parity
conditions. The topic of this research is to determine the deviations from the covered interest
parity. The interest differentials between the swap rate and the interest rates analyses for this
research study. The majority of its audiences do not aware of this concept as by conducting
this research they will get to know about all the components of an investigation. Dependent
and independent variables developed for this study to generate the outcomes of a research
study.
This the study will target several components of research such as analysing the latest
interest rates, swap rates, closing values of the exchange rates and the currency values of two
of the countries. A researcher uses the cutting-edge data in this research which allows all the
investors to get updated with the latest results and this also help a user as a quick guide to
investing in the foreign market directly. It can say that this research study will act as an
instruction manual or a study guide that allow a newbie to enter into the international
financial market and money market and invests in a suitable asset that generates a higher
return. The risks will get decreases by a user by itself by taking help of investment analysis
tools such as VAR and regression analysis as discussed in this report.
The topic of this research study is the deviations from the covered interest parity in
the Hong-Kong denote that a researcher will identify the factors that are the cause roots of the
changes in the CIP. This study will reflect the theoretical and empirical investigations
conducted in this research analysis by deeply exploring all the facts relates to this study. This
study initially conducts the literature review which will describe the theoretical perspectives
of research. The abstract framework shows the relationships of a research variable such as
overnight swaps and the NDF swap rate identifies using Vector auto-regression model to
check the relationship among these two elements.
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A Motive of a researcher behind selecting this model is to know its further impact.
The researcher analyses to know its final impact on the main objective of the research. The
interest rate differentials and the spot exchange rates of USD and HKD identify by a
researcher using simple ordinary linear coefficients tests which is one of a kind of regression
analysis that uses residual plots and line fit plots for comparing the data. This tool will show
whether the data will fit in a straight line will get out of a mark.
The empirical investigation reveals the real efforts of a researcher in performing this
research study that says about the positive or increasing trend of the currency value of US and
Hong-Kong from one period to another due to the low inflation rate. Negative estimated
results about spot exchange rates and the currency prices of two of the countries that the
unfavourable outcome signifies no correlation between these two components. The negative
consequence is determine as these affect by the external environment all the factors such as
political, economic and cultural factors are which are primary suspects of triggering changes
in the covered interest parity. By linking the singular results of all the analysis performed by
a user in this study, the final result is a summation of all the examination that says that the
covered interest parity’s condition is not as good as the deteriorated position of CIP has
witnessed by all the users. The empirical investigation along with the theoretical study will
aid an individual in compiling its final report that the research objectives successfully tested
and the result is not in favour of the party as CIP is negative.
After the completion of this research, an individual got to learn several lessons of
keeping patience, working systematically by managing the time, using authentic and reliable
information from the credible sources. All these lessons learnt from this study will help a
person in performing systematic research in the future to get it complete before the stipulated
time of research.
This study will challenges the future research scholars in terms of knowledge and
quality of information mention in a research. A user will get to know about special features
of covered interest parity by reading this dissertation. They will get an experience while
performing this study as they get a clue to perform its own research in the future by taking
help or guide for their own research.
Considering the issue takes places in research, the entire study will get changes by making
modifications in the file by changing the timeline of this project, using different
methodologies of the research study. Un-available data and time- consuming research process
will results in an estimate of project failure as due to this the interest of a researcher gets
decreases.
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CHAPTER 2 LITERATURE REVIEW AND THEORY
2.1 Literature Review
2.1.1. Changes take places in the covered interest parity in Hong Kong
Glau, Grbac, Scherer & Zagst, 2016), has asserted that covered interest parity is a
term that denotes the actual meaning of this term that shows the interest rate differential
between two currencies. The study says that the interest differential of the two currencies in
the cash market should get equal the shortcomings lie in the forward and the spot exchange
rates (Wong, Leung & Ng, 2017). The covered interest parity is a close examination of the
interest differential of the two currencies dealing in the international market to know the
impact of the external market on its trading. Increasing or decreasing covered interest parity
will, in turn, shows its overall effect on the currency value of two of the countries.
According to the viewpoint of Avdjiev, Du, Koch & Shin, 2016), says that due to the
global financial crises immense reappraisal of the third party credit risks and the liquidity
risks in the international finance market has evident. This increasing risk will, in turn, change
the currency value of the country. The fluctuating position of the covered interest parity
amazes all the economists top think over on this matter again in estimating the reasons behind
this issue (Borio, McCauley McGuire & Sushko, 2016). The London interbank offered rate
also gets increases overnight whose purpose is not certain to the investment analysts due to
which the indexed swap rate has also increased. The sudden increase in the Libor and the
indexed swap rates is to be identifying throughout the research study.
The Motive of the researcher is to understand the cause behind that why covered
interest parity is no longer exists in the international finance market as what factors triggering
positive or negative changes in the growth of CIRP. From the perspective of the lender, the
counterparty risk is essential for borrowing which is not secured through collateral security as
a lender gets no return in exchange when giving loan to the borrower (Sushko, Borio,
McCauley & McGuire, 2017). On another hand, a lending party will enjoy interest or
something in return of the loan is given to a borrower by taking collateral security in
exchange for a credit. From the angle of swap indexed rate, the interest differential is identify
which signifies the difference between the forward and the spot interest rate. The interest
differential rate will act as a benchmark rate that will help spot rate and the forward rate too
show increasing performance (Du, Tepper & Verdelhan, 2018). The investments in the stock
market will get beneficiary advantages due to the growing performance of these two rates.
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Another theory says that the difference among the domestic and foreign currencies is the
interest differential rate.
As per the viewpoint of Osei-Kyei & Chan, (2017), a factor held responsible for
changing covered interest parity in Hong-Kong is due to the transactions costs of investment
in the international finance market. Due to the existence of transaction costs, the interest rates
and the exchange rates will get parallel to each other before investing in the market. It says
that when an individual capitalizes in the market, then the interest and the exchange rates gets
equal but when the same individuals borrow from another party in same market will consider
as a foreign currency exchange.
Cheng & Wu, (2017), says that another factor causing changes in the covered interest
parity of the given country are political risk as Hong-Kong contains two financial controls
such as of the current nation and the regulation of China. Two political rules and the
conventions applicable on this country which is not beneficial for the businesses and the
individuals trade in the international market. Fluctuations in the political rules and the
regulations of the nation will directly affect the covered interest parity. This will in, turn,
creates severe changes in the interest rate as due to turbulence in the political structure of the
nation. Due to the changes in the political conditions of the nations, an investors has to face
higher interest rate which will get stabilizes by interest rate parity as this will rectify the
situations of the external market (Baldwin, Brunsdon, Gaudoin & Hirsch, 2018).
From the viewpoint of Liao, (2016), that says that withholding tax is another point
that held responsible for deviations in the interest rate parity (Halaweh, 2018). While trading
in the international market, when a domestic user pay to the foreign party then the taxes
withhold to that payment has to deposit to the government before clearing the payment made
to the other party. Poor condition of the covered interest parity of the Hong-Kong is due to
the changing taxation policies of the nation as the value of tax withhold on the payment to the
foreign party was higher than the actual payment (Kerr, 2018). This leads to the problems
which, in turn, decreases the forward and the spot rate who direct impact show on the overall
performance of the interest rate parity. Due to this situation, the value of Hong-Kong dollar
weakens as compared to other currencies in the international market (Whicher, Philbin &
Aronson, 2018). It is essential to closely observe the taxation rates and the overall structure to
safeguard the position of IRP (Interest rate parity of the nation (Zhao, Valdes-Vasquez,
Simmons & Parrish, 2018, January).
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Nishimura & Ozaki, (2017), says that liquidity preference is another issues identifies
by a researcher when detailed analysis conducted to analyse the position of the covered
interest party of the nation (van Veen, 2018). It is essential to now all the factors which is
affecting the currency value of Hong-Kong to eliminate the effect of all the factors which is
creating issues for the nation. After knowing its effect, actions will take by the government to
resolve all the issues. The liquidity of assets is to be identifying before investing in the
international market as this costs will also directly affects the interest rate parity (Levenko,
Oja & Staehr, 2019). Higher the costs involved in the converting the investments assets into
cash will increases the costs burden on an entity. The increasing liquidity costs will increases
the liquidity of an investment before its maturity which is not appropriate for investors.
2.1.2 Factors that causes differences between swap rate and interest rate in Hong
Kong
Hui, Lo & Fung, (2017), has asserted that latest research conducted to identify the
determinants held responsible for driving the Hong- Kong dollar interest rate swap spreads
are Liquidity and credit. From the perspective of the international market that considers swap
spread as an alternative way for banking liquidity (Bekaert & Mehl, 2019). Before
performing detailed analysis about these two factors that causes differences in the interest
rate and swap rate in the nation, it is essential to clarify this concept to aware its audiences
about its actual meaning and its significance.
Swap shows the trading relationship between two parties involved in exchanging cash
flows in the future period that utilizes swap interest rates (Benos, Payne & Vasios, 2018).
Commonly, fixed for floating method of swap interest rate uses by the parties to the
agreement where one party receives the variable interest rate payments and other party will
pay the fixed rate that is swap rate. The Hong-Kong dollar interest rate swap is very high as
compared to other countries in the counter market due to the favourable economic and
monetary conditions of this nation (Xia, You, Jiang & Guo, 2018).
International finance market releases two interpretations theories regarding swap
interest rates that firstly this is consider as an “ effective proxy for banking and liquidity” and
secondly, this is consider as a “ proxy for AA credit” (Fratzscher, Duca & Straub, 2016). This
theory determines two factors that cause differences between the interest rates and swap rates
in the nation. This research paper will analyses the major effect of one of a factor for the
differences caused in the swap spread.
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