Strategic Games in Asian Financial Crises: the Case of Hong Kong

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1 Strategic Games in Asian Financial Crises: the Case of Hong Kong Presented by Hui Wang Paper prepared by Heping Pan, Shan Wu, Honglei Zhang, Jiaqing Dai, Hui Wang Chinese Institute of Intelligent Finance Prediction Research Centre University of Electronic Science & Technology of China Phone: / Fax: URL:

2 Contents: 1. Introduction from Economic Finance and Behavioral Finance to Strategic Finance 2. Asian Financial Crisis: the Case of Hong Kong 3. An Incomplete-Information Zero-Sum Game of Three Camps Speculators, Government, and Masses 4. Hang Seng Index as the Battlefield 5. Scenario Tree Analysis of Strategic Game 6. Conclusions 2

3 1. Introduction Strategic Finance Behavioral Finance Economic Finance

4 2. Asian Financial Crisis July 2 - Thailand announces a managed float of the baht. The Philippines intervenes to defend its peso. July 24 - Asian currencies fall dramatically. The Malaysian ringgit was attacked by speculators. Aug The Indonesian rupiah comes under severe pressure. Oct The Hong Kong dollar comes under speculative attack; The Hong Kong stock market drops. Oct 28 - The value of the Korean won drops as investors sell Korean stocks. Nov Japanese brokerage firm, largest securities firm (Yamaichi Securities), and 10 largest bank (Hokkaido Takushoku) collapse. wush2@swingtum.com 4

5 The Case of Hong Kong In 1997, Asian miracle turned to be a disaster. Since Thailand decided to float its currency baht in July, it sent other Asian currencies under attacking. Hong Kong was not immune to the regional nightmare. The first attack on the Hong Kong dollar began on October 23, As the crisis in Asia developed into a worse situation, the impact on Hong Kong deepened. Hong Kong's stock market dropped significantly as speculators started three more attacks in Faced with the worsening economy, on 14 August, 1998 the Government changed from being a passive regulator to an active market participant by accumulating large positions in local blue chip stocks, and hostilities ended with the closing of the August Hang Seng Index futures contract. In 1999, the Government started selling those shares by launching the Tracker fund of Hong Kong making a profit of about HK$30 billion (US$4 billion). wush2@swingtum.com 5

6 3. An Incomplete-Information Zero-Sum Game of Three Camps Three Camps: International strategic speculators (S) Domestic government agencies (G) Herding masses (M) An Incomplete-Information Zero-Sum Game: Incomplete-Information Game: In this game, the three camps, or at least some of them may lack full information about the other camps (or even their own) payoff functions, about the physical or the social resources or about the strategies available to others (or even to them), or about the amount of information the others have about various aspects of the game, and so on. Zero-Sum Game: Zero-sum describes a situation in which a participant's gain or loss is exactly balanced by the losses or gains of the other participants. If the total gains of the participants are added up, and the total losses are subtracted, they will sum to zero. Here, the loss and gain of S is equal to the gain or loss of G and M. S M G wush2@swingtum.com 6

7 A Major Strategy of Speculators 东 One of Thirty-Six Stratagems Making a feint to the east and attacking in the west Attacking HKD as a catalyst trigger to prick the bubble HKD Interest rates HSI Short HSI futures wush2@swingtum.com 7

8 Major Strategy of Government First Stage HKD Passive reaction Raise interest rates Second Stage S and M short HSI and HSI futures Proactive reaction Buy index shares Maintain the peg system HSI Pull HSI up 1169 points, an increase of 17.55%, and raise HSI futures. wush2@swingtum.com 8

9 Objectives, Constraints and Capabilities Objectives: S: To obtain profits from short selling stock index futures G: To defend its currency, equalize interest rates to break the speculative cycle and remove incentives of speculators. Constraints: S: Risk control Limited capital Affected by herding behavior G: Worries about damages to its image and reputation as the freest economy 9

10 Capabilities: G: More than 860 billion US dollars foreign exchange reserves, the third largest in the world. World s perfect financial regulatory system Healthy economy Great confidence in HK dollar Chinese government as a strong backup S: Attacks on Hong Kong s peg system Large flow of hot money (short-term bank deposits and short-term securities with good liquidity) Promotion of market herding effect, attracting large number of investment funds to follow wush2@swingtum.com 10

11 Speculators Objective: S. T. R is profit. A is wealth. C is capital. t is the time scale. MV is the value of HKD. FV is the value of HSI futures. is the quantity of HKD and HSI futures. P is the price of HKD and HSI futures. f is the cost ratio. is the exchange rate. N is the profit of one pip. HSIF is the price of HSI futures. HSI is the price of HSI stocks.

12 Government Objective: S. T.

13 4. Hang Seng Index as the Battlefield 13

14 14

15 5. Scenario Tree Analysis of Strategic Game S short the HK$ and Hang Seng Index Futures S took short positions on the HK$ and Hang Seng Index Futures S took short positions on the HK$ and Hang Seng Index Futures S took short positions on the HK$ and Hang Seng Index Futures. G bought HK$ and raised interest rates. G bought HK$ and raised interest rates. G actively bought HK$ and raised interest rates. The linked exchange rate maintained. HSI fell. The linked exchange rate maintained. HSI fell. The linked exchange rate maintained. HSI fell. wush2@swingtum.com 15

16 S took short positions on the HK$ and Hang Seng Index Futures S took short positions on the HK$ and Hang Seng Index Futures S closed the August HSIF and short sell the September HSIF G bought HK$ and put it back to the banking system to maintain interest rates. G used exchange fund and land fund to buy bluechip shares of the HSI and to raise the index futures G used 50 billion HK dollars to intervene in the market. G intervened in the market and raised the September index futures. The linked exchange rate maintained. HSI fell. HSI redounded 560 points and closed at 7224 points. HSI surged 317 points and closed at 7845 points. The linked exchange rate maintained. HSI rose. wush2@swingtum.com 16

17 G actively short HSIF, and speculators followed the trend S sold off blue chips and large European fund entered the market. S took short positions on the HK$ and Hang Seng Index Futures G spent 200 billion HK dollars. G still intervened in the market, and pulled HSI up 1169 points, an increase of 17.55% G unveiled seven new monetary measures to strengthen the peg system and to ease extreme volatility of interbank rates. HSI plunged 160 points and then went back to its original level. HSI closed at 7922 points and rose 88 points. HSI finally closed at 7829 points, and HSIF settled at 7851 points. wush2@swingtum.com 17

18 6. Conclusions Hong Kong provides the first case of its kind in the history of modern financial markets in the sense that it was the first time an explicit strategic game was played speculators, government agencies and masses. The complexity of this strategic game is so overwhelming that we must combine game-theoretical reasoning, macroeconomic analysis and behavioural dynamics of financial markets in a retrospective analysis. The game-theoretical analysis starts with a clarification of the initial situations of the major players and their objectives, capabilities and constraints. It then proceeds to generating multi-stage game scenario trees. Wins or losses of each camp at each stage are evaluated, and consequences and lessons are discussed. This research reminds us that strategic finance may emerge as a new level of understanding on top of economic finance and behavioural finance. wush2@swingtum.com 18

19 Thanks for your attention! 19

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