The effects of Exchange-rate Market Disequilibrium on stock price predictability and property stock performance under a Currency Board system
Abstract of thesis entitled
The Effects of Exchange-Rate Market Disequilibrium on Stock Price Predictability and Property Stock Performance under a Currency Board System
Victor C. Cheung
for the degree of Doctor of Philosophy
at the University of Hong Kong
in May 2005
This thesis examines how the Exchange-rate Market Disequilibrium (the EMD) resulting from a significant shock can lead to the short-term stock price predictability in a developed and open stock market under a Currency Board system.
A significant shock is defined as any external shock giving rise to the EMD such that: (1) the fixed exchange-rate becomes over-valued and necessitates the operation of the abnormal mechanism of the Currency Board to maintain it; and (2) the market fears that devaluation or de-linking will have a long-term detrimental effect on the economy.
This study hypothesizes that the EMD causes the short-term stock price predictability. Under a Currency Board system, the stock market is closely linked to the exchange-rate market. When the exchange-rate market is in disequilibrium, an excess-return opportunity arises in the exchange-rate market (that is, trading against the over-valued currency), and then spills over the stock market, for three reasons: (i) a downward asset price adjustment under the currency rigidity, (ii) a confidence crisis resulting from the possible de-linking, and (iii) the negative impact of operations by the Currency Board, such as a rise in the interest rate. Thus, if the government only concentrates on using the Currency Board? operation to uphold the currency in the exchange-rate market, speculators, especially the macro hedge funds, have a good chance to capture the excess returns in the exchange-rate market and/or the stock market. However, in a developed
stock market, speculators need to act in collusion to fully capture such excess returns. Because the EMD offers high excess returns and a low downside risk (limited to the loss in the exchange-rate market resulting from the Currency Board? measures) and the number of colluders is relatively small, collusion is possible and sustainable. Since collusion creates the information asymmetry in the stock market, the stock prices become predictable, until collusion or the EMD ceases (for instance, as a result of the government intervention in the stock market or the changes in the fundamentals).
To substantiate this hypothesis, this thesis examines the patterns of the stock and exchange-rate returns in Hong Kong in the summer of 1998 (shortly after the Asian financial crisis and during which the exchange-rate was upheld with the interest-rate hikes) to identify the EMD, collusion, and stock price predictability. Our findings support the hypothesis. The results show that (1) the property stock, whose underlying assets are long-lasting, immobile and capital-intensive properties, declined more than the other stocks in this period, suggesting that it was an EMD period in which the market felt that de-linking would have a detrimental long-term effect on the economy; (2) the collusion signals prevailed in this period, indicating the sustainable collusive trading activities; and (3) the stock price was predictable in this period, and unpredictable otherwise.
This study has important implications. (1) The ?MD factor?is identified as an ?nomaly?that contradicts the Efficient Market Hypothesis. (2) A currency board system unintentionally strengthens the link between the exchange-rate and stock markets, which can lead to the spillover of the informational inefficiency from one market to another. (3) Despite the high costs of enforcing the underlying informal contract or agreement, collusion is possible and sustainable in a favorable environment like the EMD. (4) The activities of the large international speculators do not always improve market efficiency.
School:The University of Hong Kong
School Location:China - Hong Kong SAR
Source Type:Master's Thesis
Keywords:foreign exchange rates market currency boards stocks prices
Date of Publication:01/01/2005