How Credible Is Hong Kong’s Currency Peg? Insights from Option Prices and Asset-Pricing Models

Urban J. Jermann | Bin Wei | Vivian Z. Yue

Aug 13, 2025

Key Takeaways

Research question: How do financial markets perceive the risk that Hong Kong’s currency peg will collapse?
Approach: We estimate an asset-pricing model using exchange-rate and options data from 2007–2025, incorporating the possibility that the currency peg may break with a nonzero probability.
Findings: During stress episodes as in late 2022, the market-perceived probability of peg survival dropped to 50%.
Implications: Peg credibility is shaped by local liquidity, US interest rates, and Chinese yuan movements. Option prices contain important signals for currency regime stress.

Source Publication: Jermann, U., Wei, B., Yue, V. (2025). How Credible is Hong Kong’s Currency Peg? SSRN Working Paper

Background and Research Questions

Since 1983, Hong Kong has operated under a currency board regime in which every HKD in circulation is backed with US dollar reserves and the exchange rate is fixed at near 7.8 HKD per USD. This Linked Exchange Rate System (LERS) has anchored financial stability through several crises, including the 1997 Asian Financial Crisis and 2008 Global Financial Crisis (GFC).

But recent developments have revived doubts about the peg’s durability. Rising US interest rates, weakening local liquidity, and closer financial ties with mainland China have created fresh pressure. In late 2022, the HKD hovered near the weak end of its trading band (7.85), prompting repeated HKMA interventions and a steep fall in the Aggregate Balance, the main liquidity measure of the HKD system. In recent months of 2025, the HKMA has increased interventions again, due to HKD fluctuations and growing interest rate differentials.

Methodology

We develop an asset-pricing framework that allows the HKD/USD peg to be imperfectly credible. If the peg continues, the HKD is kept within the 7.75–7.85 band. If the peg breaks, the HKD shifts to its “fundamental value” (V), determined by fundamentals such as interest rate differentials and capital flows.

We derive both the equilibrium exchange rate and option prices in closed form. The model produces a U-shaped exchange-rate distribution with higher density near the band edges as in the data, which is in contrast to the bell curve implied by standard Black-Scholes models.

Findings

Using data from 2007–2025, especially out-of-the-money option prices, we estimate a market-perceived probability (p) that the peg will hold, the underlying “fundamental value” (V), and implied volatility. We find several episodes in which market confidence in the peg was seriously weakened. Most notably, in late 2022, our estimate shows a sharp decline in peg credibility. The estimated probability of peg survival (p) dropped to ~50%, coinciding with aggressive US Fed rate hikes, outflows from HKD assets, and a plunge in the Aggregate Balance from over HK$300 billion to below HK$100 billion. Other stress events include the following: 2008–09, when the GFC led to volatility spikes; August 2019, when the yuan weakened (CNY > 7 per USD) amid U.S.–China trade tensions; and 2025, when the peg faced pressure from both directions as rapid swings in capital flows challenged the peg’s credibility by destabilizing local interest rates and liquidity conditions.

Figure: The blue line in Panel (a) plots the three-month probability p that the HKD peg remains credible in 90 days. The red line is the spot USD-HKD exchange rate. The shaded area is the band set for the USD-HKD exchange rate. Panel (b) plots the estimated fundamental exchange-rate value V.

Regression results show several variables are associated with shifts in peg credibility and the HKD’s fundamental value. Higher Hong Kong interest rates are linked to stronger peg confidence, whereas higher US rates are associated with lower credibility and a weaker HKD value. Interbank liquidity, as measured by the aggregate balance, also tends to reduce at times when market confidence is low, due to the HKMA intervention. In addition, a depreciation of the Chinese yuan is found to be associated with lower peg credibility and expectations of a weaker HKD.

Conclusion

Hong Kong’s currency peg remains intact, backed by strong reserves and institutional credibility. Yet, financial markets do not treat it as guaranteed. Our findings suggest peg credibility fluctuates meaningfully over time, driven by global and regional macro forces. By extracting probabilities from options data, we provide a real-time lens into this evolving risk.