Do Derivative Markets Contain Useful Information for Signaling "Hot Money" Flows?

This study examines whether information from derivative markets is useful for signaling "hot money" and other large capital flows in an economy where the monetary authority pursues a policy of exchange rate stability. Specifically, this study examines the information content of various Hong Kong traded derivative securities for signaling changes in the aggregate balance of the Hong Kong banking system during a period of intense IPO activity and speculation on the revaluation of the renminbi. The impact of the introduction of the Hong Kong Monetary Authority's (HKMA) Convertibility Undertakings on the dynamic relationships among capital flows, stock market volatility and stock market turnover is also examined. Finally, the implications for monetary policymakers in potentially using information from derivative markets are assessed. The results show that derivative markets contain useful information for signaling "hot money" flows. Granger causality tests from a VAR model show that Hong Kong dollar forward and RMB non-deliverable forward (NDF) prices predict future variation in the aggregate balance. Moreover, changes in aggregate balance has a significant impact on Hong Kong's interbank rates. The findings also suggest that the introduction of the May 18, 2005 Convertibility Undertakings may have increased the credibility of the Linked Exchange Rate System by discouraging the use of the Hong Kong dollar and Hong Kong dollar denominated assets as speculative vehicles on RMB denominated assets.