Interest Rate Differentials Under an Exchange Rate Convertibility Zone

This study rationalizes the negative HKD-USD interest rate (HIBOR-LIBOR) differentials observed after the US interest rate hike on December 17, 2015. Why do arbitragers not eliminate the differentials until parity? We first analyse two practical concerns that are typical from the perspective of a carry trader: (1) the difference in borrowing rate and lending rate of a currency, and (2) the exchange rate loss perceived from prevailing HKD/USD market condition using a truncated distribution that reflect full confidence in the HKD/USD Convertibility Zone un­der the Linked Exchange Rate System (LERS). We find that these considerations largely explain the observed interest rate differentials. We then perform robust Bayesian statistical inference on the negatively skewed effective carry-to-risk ratios. We find that the most probable and the typical effective carry-to-risk ratios are eco­nomically small. Our results are consistent with the Hong Kong Currency Board's intrinsic stabilizing mechanism functioning efficiently