The twin faces of emerging Asia's currency forward markets in an imperfect setting

Abstract

Covered interest parity fails to occur in both the onshore and offshore currency forward markets for emerging Asia. The deviation is largely influenced by a two-tier currency forward market given the barriers to capital flow, with the exception of Hong Kong. The structural difference between onshore and offshore currency forward markets lends support for arbitrageurs to exploit the segmentation of markets.

Keywords:

• deviation from covered interest parity
• nondeliverable forward markets
• emerging Asia
• Mundell Fleming
• currency forwards

JEL Classification:

• C32
• E00
• F41
• F31
• F37

Notes

1  The forward rate is said to contain a premium or discount, reflecting the interest rate differential between two countries. (1 + P) where, P is the premium (if positive) or discount (if negative). is the forward currency contract and S is the spot exchange rate. In practice, forward premiums and discounts are quoted as annualized percentage deviations from the spot exchange rate, in which case it is necessary to account for the number of days to delivery as in the following example P_N  = , N represents the maturity of a given forward exchange rate quote and d represents the number of days to delivery.

2  Ḟ – F is the forward gap between the Ḟ equilibrium forward rate and the actual currency forward in the onshore and offshore market. Two equilibrium forward rate is identified, one for the onshore and the offshore market. The currency return is measured as the difference between the implied yield from the currency forward and the difference against the 3-month Dollar Libor rate. Where the implied yield is The equation is estimated using least square and adjusted to percentage terms.

3  The DFFITS is the scaled difference in fitted values for the observation between the original equation and an equation estimated without that observation. Scaling is done by dividing the difference by an estimate of the SD of the fit. ] e is the original residual for each observation of k, s is the variance of the residual that would have resulted had observation k not been included in the estimation and h is the k-th diagonal element of the Hat matrix xk′ (X′ X)⁻¹ xk.

4  All data that is used for this analysis was sourced from Reuters.

5  The interbank rates are China – 3m Shanghai Interbank Offered rate, India – 3m Mumbai Interbank Offered rate, S. Korea – 3m Certificate of Deposit rate, Taiwan – 3m Commercial Paper, Hong Kong – 3m Hong Kong Interbank Offered rate, Singapore – 3m Swap offered rate, Indonesia – 3m Average Auction yield paper, Thailand – 3m Bangkok Fixing rate, Malaysia – 3m Kuala Lumpur Interbank Offered rate, Philippines – 3m Reference rate.

6  Equation 5 is estimated using a least square approach, in the following manner,  + κ, with c as a constant and κ as the error term.

7  Herman Kamil and Alejandro Reveiz, Carry Trade and Derivatives market in Columbia, Mechanisms and Policy Implications, Regional Workshop on Derivatives Market, 24 April 2008.

8  Equation 6 is estimated using a least square approach, in the following manner,  + κ, with c as a constant and κ as the error term.

9  Tsuyuguchi and Wooldridge (2008) find that activity in the Asian currencies is concentrated in onshore markets to a much higher degree than other major currencies. This indicates that foreign exchange controls are having the intended effect of stalling the internationalization of Asian currencies and therefore potentially hindering the integration of Asian financial markets with world markets. The authors also find that foreign exchange controls are restraining the development of Asian foreign exchange markets by depressing derivatives trading and segmenting activity between onshore and offshore markets.

10  The sale and purchase of foreign exchange are subject to stringent controls and this adds to the difficulties currency traders face in finding counterparties with whom to hedge or close out their positions.

11  C. Kriljenko (2004) conclude in their findings that foreign exchange regulations and the role of the central bank heavily influence the structure of the market. Consistent with the findings of Miniane (2004) and Tsuyuguchi and Wooldridge (2008), the relatively low share of trading with onshore agents in the foreign exchange markets is due to Asia's low degree of capital mobility. Foreign exchange turnover and the mechanism of reaching equilibrium is higher in countries with open capital accounts. Low barriers to inward and outward investment facilitate the international diversification of portfolios.

12  Herstatt risk is a form of settlement risk in currency markets that occurs when counterparty does not deliver the security or its value in cash as per agreement when the security was traded after the other counterparty had delivered the security or its value in cash as per the trade agreement. The Herstatt risk is named after a German bank that made a famous example of the risk on 26 June 1974, the bank's license was withdrawn by German regulators at the end of the banking day (4:30 pm local time) because of a lack of income and capital to cover liabilities that were due. But, some banks had undertaken foreign exchange transactions with Herstatt and had already paid Deustche Mark the bank during the day, believing they would receive US dollars later the same day in the US from Herstatt's US nostro account. But after 4:30 pm in Germany and 10:30 am in New York, Herstatt stopped all dollar payments to counterparties, leaving the counterparties unable to collect their payment.

13  The Continuous Linked Settlement (CLS) system was launched in 2002 based in Hong Kong to eliminate the risk associated with foreign exchange transactions. Only three Asian currencies can be settled through this system, the SGD, HKD and KRW. For those not settled through this system, a HKD–US Dollar real time gross settlement (HKDRTGS) was introduced in Hong Kong in 2000 and a EUR real time gross settlement EURRTGS) introduced in 2003. The HKDRTGS system facilitates the payment for HKD–USD and HKD–EUR transactions. Malaysia linked its MYRRTGS system to Hong Kong's USDRTGS system in November 2006, and in 2007 almost 60% of the MYR–USD trades in Kuala Lumpur are settled simultaneously through this system (Bank Negara Malaysia 2008). In the case of nondeliverable forward currencies of emerging Asia which are traded in the offshore market, the CLS has a dedicated system of matching these trades. This includes all emerging Asia currencies to reduce the cost of transaction and to improve efficiency in trading nondeliverable forward currencies. The CLS settlement for nondeliverable forward currencies offers a complete straight through process, post-execution of trades to settlement, capturing various instructions for the life of the contract and provides matching, settlement and reporting services (see http://www.cls-group.com).