Question

In 1998, hedge funds attack HK currency, stock, and futures markets. Can you display the hedge funds' positions with precise futures data? And how did they roll their positions?

Answer 1

HONG KONG–

The Hong Kong Government intervened the local market on August 14，1998， claiming that the market was under manipulation or "double play' as criticized by Joseph Yam, the chief executive of Hong Kong Money Authority. Hedge funds are criticized as culprits for attacking the Hong Kong Dollar, making the HIBOR (Hong Kong Inter Bank Offer Rate) rise and making profits from shorting Hang Seng Index Future at the same time. In addition, they are blamed for manipulating the Hang Seng Index and being responsible for the crash of Hang Seng Index in the Asian Turmoil Period. We have built a value-weighted index (vw38) of 38 hedge funds with the largest net asset value and have selected Jaguar Fund NV and Quantum Fund NV as our case studies to test the hypothesis of double play and manipulation of the Hang Seng Index stock market during that period. We try to estimate the dynamic dollar positions of the thirty-eight hedge funds and the two individual funds in the 2-month HIBOR, current Hang Seng Index Future and Hang Seng Index markets with 10 years' data from October 1988 to October 1998. We employ Sharps Style Analysis and run rolling regressions with a frame of 7 months to estimate the dollar positions of hedge funds by multiplying the betas to the corresponding net asset values. We find that the interest market was generally not under manipulation by hedge funds in the turmoil period. There is no doubt that the dollar position of hedge funds included in the value-weighted index in the 2-month HIBOR market is an important factor affecting the interest market. But this is more so before the turmoil.period when interest rates were low and stable than during the turmoil period when interest rates fluctuated. Dollar positions of hedge funds were just one of the many factors causing interest rates to overshoot during the turmoil period. On the other hand, the Hang Seng Index Future and Hang Seng Index markets were clearly manipulated by hedge funds during the turmoil period when they demonstrated abnormal profit patterns in the Hang Seng Index Future market Our results show that the hedge funds did double play the market and manipulate the Hang Seng Index to make profit. The results for the Jaguar Fund NV and the Quantum Fund NV are similar except that the dollar positions of Jaguar Fund NV are not significant to the 2-month HIBOR market and that the dollar positions of Quantum Fund NV are much larger than tiie industrial average. The Asian Turmoil which saw capital outflow from most Asian regions including the Hong Kong SAR, coupled with the overheated economy after the handover in Hong Kong, makes the Hong Kong markets especially vulnerable to such attacks by hedge funds. Intervention by the Hong Kong SAR government was clearly needed to keep a healthy and stable financial market for the sake of social stability.

The government maintains that big hedge funds that wager huge sums in global markets had been scooping up big profits by attacking both the Hong Kong dollar and the stock market.

Under this city’s pegged-currency system, when speculators attack the Hong Kong dollar by selling it, that automatically boosts interest rates. Higher 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’ abilities to borrow and expand.

Speculators make money in a falling stock market by short-selling shares—selling borrowed shares in expectation that their price will fall and that the shares can be replaced more cheaply. The difference is the short-seller’s profit.

“A lot of hedge funds which operate independently happen to believe that the Hong Kong dollar is overvalued” relative to the weak economy and to other Asian currencies, said Bill Kaye, managing director of hedge-fund outfit Pacific Group Ltd. Mr. Kaye points to Singapore where, because of the Singapore dollar’s depreciation in the past year, office rents are now 30% cheaper than they are in Hong Kong, increasing the pressure on Hong Kong to let its currency fall so it can remain competitive.

Hedge funds, meanwhile, “are willing to take the risk they could lose money for some period,” he said, while they bet Hong Kong will drop its 15-year-old policy of pegging the local currency at 7.80 Hong Kong dollars to the U.S. dollar.

These funds believe they can wager hundreds of millions of U.S. dollars with relatively little risk. Here’s why: If a hedge fund bets the Hong Kong dollar will be toppled from its peg, it’s a one-way bet, according to managers of such funds. That’ s because if the local dollar is dislodged from its peg, it is likely only to fall. And the only risk to hedge funds is that the peg remains, in which case they would lose only their initial cost of entering the trade to sell Hong Kong dollars in the future through forward contracts.

That cost can be low, permitting a hedge fund to eat a loss and make the same bet all over again. When a hedge fund enters a contract to sell Hong Kong dollars in, say, a year’s time, it is committed to buying Hong Kong dollars to exchange for U.S. dollars in 12 months. If the currency peg holds, the cost of replacing the Hong Kong dollars it has sold is essentially the difference in 12-month interest rates between the U.S. and Hong Kong.

Whether a fund manager wanted to make that trade depends on the odds he assigned to the likelihood of the Hong Kong dollar being knocked off its peg and how much he expected it then to depreciate.

If he believed the peg would depreciate about 30%, as a number of hedge-fund managers do, then it would have made sense to enter the trade if he thought there was a one-in-four chance of the peg going in a year. That’s because the cost of making the trade—US$63,000—is less than one-fourth of the potential profit of a 30% depreciation, or US$300,000. For those who believe the peg might go, “it’s a pretty good trade,” said Mr. Kaye, the hedge-fund manager. He said that in recent months he hasn’t shorted Hong Kong stocks or the currency.Wall Street Journal, August 24, 1998.