An Analytical Framework for the Hong Kong Dollar Exchange Rate Dynamics under Strong Capital Inflows

Between the fourth quarter of 2008 and the end of 2009, the strong-side Convertibility Undertaking was triggered repeatedly with remarkable capital inflows into the Hong Kong dollar. In view of this development, this paper proposes an analytical framework to understand the relationship between a two-sided target zone regime and equity market. The framework features non-trivial portfolio choices among risk-free bonds and risky assets offered in the domestic and foreign economies, where the exchange rate between the two economies is managed through a two-sided target zone regime. Our simulation results show that the equity-return differential between the two economies serves as a counter-balance factor of the risk-free interest-rate differential in determining the movements of the exchange rate.