A Hedge Fund is a fund established by one or several partners with net worth of at least $1 million (although this maybe falling). It uses long and short positions to take speculative positions in multiple markets simultaneously. (Regular equity funds are not allowed by law, to short securities.) Hedge funds use leverage and trade derivatives in order to maximize returns. After the leverage effect Hedge Funds command large amounts of resources. Their positions can significantly affect markets, particularly those markets that are relatively less liquid.
Hedge Fund have been playing a no-lose game
In the simplest strategy a hedge fund borrows Hong Kong dollars(HKD) and
then sells them in the market against USD, i.e., they short the HKD. Note that this will cause the money supply to shrink. A decrease in money supply leads to an interest rates increase. Increases in interest rates have several effects on the stock market. First borrowing HKD to buy stocks becomes more expensive. Hence fewer investors would use margin. Second, an increase in deposit interest rates will draw funds from stocks to deposits. Third, interest rate increases are negative for businesses and their value will go down. Again stocks decline.
On the other hand, higher interest rates lure more investors to park their money in Hong Kong, boosting the currency. But they also slam the stock market because rising rates hurt companies’ ability to borrow and expand. However, many of these Hedge Funds involved in the speculation did not operate in the cash market. instead they shorted the HKD in the futures markets. This does not require borrowing HKD. It is the counter party who has to hedge the long HKD position who needs to “borrow HKD” from the banking system. In the particular case discussed here Hedge Fund managers believed that they were taking little risk:
• The hedge funds bet on the collapse of the peg. If the peg breaks, the HKD is expected to fall. Given the psychology of those days, the casual view was that the HKD was overvalued. The only risk to Hedge Funds is that the peg holds. Under these conditions their loss will be the difference between the initial cost of entering the trade to sell HKD in futures markets and the pegged rate. The reading suggests that this cost is low.
Hedge Fund enters contract to sell HK$ in six month’s. At expiration the Hedge Fund needs to buy spot HKD and delivered these against the short future’s position. If the peg holds the cost of replacing the HKD it has sold is essentially the 6 month differential between USD and HKD interest rates. On Thursday August, 20th the difference 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.) So a hedge fund manager making a USD 1 million bet Thursday against the HKD would have paid USD 63,000. If the fund manager believed that the peg would break and thus the HKD depreciate, say, about 30%, then the potential profit would be USD 300,000. Compared to the cost of making the trade, USD 63,000 this is a good profit.
HKMA intervened to defend the peg. Using its own FX reserves, MA sold USD. Normally, when a country with a pegged currency spends reserves to defend the currency’s value, the intervention will have to be “sterilized”. In other words, the central bank would buy local currency bonds from the banking system so the purchase will be roughly in similar quantities so that the overall monetary base remains constant. However, doing this in Hong Kong at that time would result in further increases in interest rates. This would be considered as severely harmful by real estate companies in Hong Kong.