Exchange Rate Risk Premiums in Hong Kong Dollar: A Signal-Extraction Approach

Abstract

Forward exchange rates convey information about the risk premiums of the currency exposures of the investors. The extraction of these risk premiums provides market information for the expected future values of a currency, which may be useful for policymakers in their market surveillance and monitoring. This study utilises a state-space model and the Kalman-filtering technique to estimate risk premiums of Hong Kong dollar from the forward exchange market from 1996 to 2005. The estimated risk premiums of the 12-motnh forward contract were as high as 3.4% of the spot exchange rate during the Asian financial crisis in 1998. The study also finds that the risk premiums have reverted from a discount in late 2004 to close to zero in mid-2005, reflecting that the appreciation pressure on the Hong Kong dollar along with the speculation on the revaluation of the renminbi in early 2005 has subsided after the introduction of the three refinements to the operation of the Linked Exchange Rate system in May 2005 and the reform of the renminbi exchange rate regime in July 2005. The forward exchange rates, after taking the estimated risk premiums into account, do not have a good forecasting capability for the future spot exchange rates. Among the two financial factors that drive the risk premiums in the Hong Kong dollar forward rates, the renminbi non-deliverable forward rates appear to have a larger impact than the Aggregate Balance of the banking system. Nonetheless, both factors are important for monitoring the risk premiums of the Hong Kong dollar exchange rate.