Risks Behind Yield Differences in HKD and USD Government Bonds
Summary
The document examines why lower yields on Hong Kong dollar government bonds than on US dollar bonds do not necessarily create a risk-free arbitrage, even though the currencies are pegged. The responses identify possible loss of the peg, restrictions on currency conversion, and differences in perceived inflation or default risk as factors that can contribute to yield spreads. A peg does not eliminate the possibility that investors price risks specific to the currency or issuer.
The discussion also highlights spread and leverage risk. A trade intended to earn the yield differential over a long horizon can suffer mark-to-market losses if the spread widens before maturity. Leverage can magnify those losses and potentially force an early exit. The responses disagree about whether expected future spread changes are a sufficient explanation for current yield differences, so the document does not establish a single definitive account. Its examples are illustrative and do not constitute a full valuation or trade analysis.
Key ideas
- A currency peg does not eliminate the risk that the peg may break or that conversion may be restricted.
- Yield spreads can widen, creating mark-to-market losses during a long holding period.
- Leverage magnifies losses from adverse spread moves and can force a trade to close before maturity.
- Differences in perceived inflation and default risk can help explain yield differences across currencies.
- The responses differ on whether expected future spread movements alone explain the current yield gap.
Tags
Full text
# What is stopping traders from arbitraging HKD-USD? # What is stopping traders from arbitraging HKD-USD? I observed the yield of HKD goverment bonds is quite materially lower than USD for quite a long time. For example the $10$ year gov yield of HK government bond was $3.174 \%$ versus $4.167 \%$. This is quite odd to me, as the two currencies are pegged, so it seems to be an arbitrage. Even if there are depegging risk, that should not favour HKD, so it doesn't support the low HKD yield curve. Are there any risks in this trade that I am not seeing? ## Answer by Chris Taylor (score 15) https://quant.stackexchange.com/a/82419 - Possibility of depegging - Risk of a further increase in the spread between yields. To capture this "arbitrage" you would need to hold for 10 years, during which you could suffer mark to market losses. - Necessity of using leverage. You capture about 1% per year per dollar invested, and you lose ~0.1% for every basis point that the spread moves against you. If you used 10x leverage to capture ~10% per year, then a further widening of the spread by 0.1% would cost you 10% in drawdown, wiping out your annual profits. A widening of the spread by 0.5% would cost 50% in drawdown, almost certainly forcing you to unwind the trade at a loss. ## Answer by Dimitri Vulis (score 4) https://quant.stackexchange.com/a/82423 I'm guessing that some speculators express views on whether/when the peg would break, how what the rate might become afterwards. This has been going on for years. Sample news items: - 2022: Tom Westbrook, Billionaire investor Ackman bets Hong Kong dollar peg can break, Reuters, November 24, 2022. Tom Westbrook, Georgina Lee, Improbable bets on break of Hong Kong dollar peg adding up, Reuters, December 5, 2022. - 2023: Laura He, Why Hong Kong can’t afford to keep its currency pegged to the US dollar, CNN, June 13, 2023. - 2024: Yong Jian, Hong Kong dollar peg at risk in Trump’s coming fight with China, Asia Times, December 26, 2024. - 2025: Enoch Yiu, Hong Kong’s US-dollar peg gets emphatic defence from HKMA CEO, SCMP, 9 January 2025. ## Answer by Acccumulation (score -1) https://quant.stackexchange.com/a/82425 Pretty much all of bond yields come down to default risk, expected inflation, and time value of money. In an efficient market, the time value of money should be the same regardless of location, so that leaves the first two. The possibility of the currency becoming unpegged can be analyzed as an inflation risk, or as effectively a soft default. You also have the risk of currency controls, which is effectively a soft unpeg. So "default risk" can be considered to encompass the main reasons for yield difference. Chris Taylor gives the partial answer of possibility of unpeg as his first item. His third discusses leverage, but the leverage risk he describes refers back to future spread between yields, so he really only has two items, and his second doesn't make sense. If we explain yield difference 10 years from maturity on the basis of the possibility of even larger yield differences 9 years from maturity, then that raises the obvious question of why there would be yield differences 9 years from maturity. Those differences can be explained in terms of either default risk or the possibility of yield differences 8 years from maturity. But then that raises the question of why there would be yield differences 8 years from maturity. And so on. We have to either cite default risks eventually, or we get to the point of positing that the bonds could have differing discounts all the way up to maturity, which is absurd.
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