Improbable bets on break of Hong Kong dollar peg adding up By Reuters

By Tom Westbrook and Georgina Lee

SINGAPORE/HONG KONG (Reuters) -It’s what is known in the markets as a “tail risk”: a highly unlikely scenario in which Hong Kong’s currency peg suddenly snaps. Yet market pricing suggests bets on such a shock are building in the hedge fund world, and some traders say it makes a lot of sense.

Billionaire money manager Bill Ackman went public last month with his wager that the days of the Hong Kong dollar’s 39-year-old peg to the U.S. dollar are numbered.

Ripples in the derivatives market imply he is not alone, as “macro” trading – or betting on big global shifts – swings back into vogue and the prospect of reaping a huge reward for relatively little risk revives a perennially unsuccessful trade.

Most fundamental analysts say such bets are foolish, pointing to the city’s still massive reserves and China’s backing.

But they can be relatively cheap and even profitable regardless of the peg staying intact, and it buys insurance against unlikely but not impossible chains of events, such as a sudden blow-up in China, devaluation or a geopolitical chill.

“For me, the Hong Kong dollar peg is like a delayed, or lagging bet against China,” said Diego Parrilla, who runs Quadriga Igneo, a $240 million fund designed to profit from market turmoil.

“You are taking advantage of the extreme complacency of the market,” he said. “The downside is limited to the premium spent…I’m risking very little and can make a lot.”

Saba Capital founder Boaz Weinstein is also positioned for a break of the peg, and said on Twitter the payoff could be “upwards of 200-to-1”.

The cost and size of these positions is unclear, but Ackman and Parrilla have said their bets are placed using options.

Options are contracts that, for an up-front fee, allow investors to bet on the movement of asset prices without the risk of losses beyond the initial fee, and there are signs that such bets are picking up.

A measure of the spread, or skew, between puts and calls in the options market has hit its widest in about three years in favour of U.S. dollar calls, suggesting bets against the Hong Kong dollar are becoming a little more crowded.

The Hong Kong dollar has been pegged in a tight band between 7.75 and 7.85 per greenback for nearly four decades. Its stability and fungibility have been major foundations for Hong Kong’s success as a financial centre and a hub for money moving into and out of China.

STATUS QUO

China rarely comments on the peg, but in 2014 its cabinet said the government would “firmly support” Hong Kong in maintaining the peg and the stability of the city. The Hong Kong Monetary Authority (HKMA) says it has “no need and no intention” to change the system, and sufficient reserves to defend the peg.

The HKMA maintains the peg by moving interest rates in lockstep with the United States, and by currency…