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Net Net: Promoting innovation and managing change

How Ackman's Hong Kong Dollar Bet Works

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When Pershing Square founder Bill Ackman advocated buying Hong Kong dollar call options Wednesday, I was a bit surprised that such things even exist.

Is there really a market for options on a pegged currency?

The Hong Kong dollar is pegged to the U.S. dollar by government policy. This means that the Hong Kong monetary authorities attempt to keep the Hong Kong dollar inside a 10 cent band, so that it never trades at greater than HK$7.85 per U.S. dollar, or less than HK$7.75.

Do investment banks really offer products that allow traders to speculate that the policy will fail or be changed?

The answer is yes. I spoke to a trader who told me that its often used to hedge risk of policy changes, and not often used as a directional bet in the way that Ackman advocates.

Gerrard Katz, head of foreign-exchange trading for Asia at BBVA, told the Financial Times that the trade is relatively cheap to put on. You can buy a call option at the lower level of the band for just 85 basis points. In other words, for just $8,500 you can buy the right to purchase $1 million U.S. dollars for $7.75 million Hong Kong dollars in 12 months time. If Hong Kong dollars are allowed to appreciate, the bet would pay off handsomely.

From the FT:

In the unlikely event that the Hong Kong dollar was revalued against the U.S. dollar by, say, 30 percent before the option expired, to a new level of HK$5.96, then the put option would result in a profit of $292,000—or a 36-fold return on the original investment.

However, the reason these options are cheap in the first place is because the prospect of Hong Kong officials engineering a one-off revaluation against the U.S. dollar is extremely remote. While such a move could, in theory, dampen inflationary pressures, it would also destabilize Hong Kong’s export-driven economy and invite speculative capital inflows.

Ackman has billions under management. He says he has taken a relatively small position on this currency trade, but that if it works it will be the his most successful trade ever.

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