How Credible Is Hong Kong's Currency Peg? Insights from Financial Market Prices

Data Stories in a Minute:

Summary:

This article presents a structural asset-pricing model that quantifies financial market perceptions of the credibility of Hong Kong's Linked Exchange Rate System (LERS). Using data from the foreign exchange market, the authors estimate the probability that the Hong Kong dollar (HKD) remains pegged to the US dollar (USD) and the value the HKD would take if the peg were to break. The analysis reveals multiple episodes when market confidence in the peg declined, with particularly sharp stress in late 2022 and mid-2025. In these periods, capital flows, interest rate differentials, and liquidity shocks drove market expectations of peg instability. The model identifies option prices as key forward-looking indicators of regime risk. This framework provides a real-time, market-based tool for monitoring currency peg credibility. The findings also offer policy-relevant insights into how global monetary shifts and local liquidity conditions shape perceptions of exchange rate stability.

Key findings:

1. Our asset-pricing model for the Hong Kong dollar exchange rate estimates that financial markets participants assign fluctuating-but sometimes substantial-probabilities to the peg breaking, especially during periods of monetary divergence or capital flow volatility.
2. Credibility is driven by factors including interest rate differentials, interbank liquidity, and China's currency renminbi movements. Financial derivative data such as optionimplied volatility are strongly associated with market perceptions of peg sustainability.
3. Compared to standard benchmarks, our model offers a more accurate, real-time gauge of peg risk and can serve as an early warning tool for policymakers in Hong Kong and beyond.

Center Affiliation: Center for Quantitative Economic Research

JEL classification: F31, F42, E42, E44, G12, G15

Key words: Hong Kong dollar, currency board, peg, exchange rate model, option prices

https://doi.org/10.29338/ph2025-05