Chinese Exchange Rate Policy: Lessons for Global Investors

Chinese currency policy has had a strong impact on the value of investors’ portfolios in recent years. On August 11, 2015, the People’s Bank of China announced a new exchange rate policy where the RMB central parity rate against the USD would be determined each morning by the previous day’s closing rate, market demand and supply, and valuations of other currencies. This new policy suggests an implementable investment strategy for trading the CNH. In this paper we create a forecasting model based on information regarding the central parity rate, implied volatilities and other control variables which correctly predicts the direction of change on about 60 percent of days. The exchange rate forecast is then used to manage the global investor’s problem of mitigating the currency risk inherent in Chinese equity positions. All currency hedging strategies are shown to add value to the equity portfolio. A dynamic currency overlay strategy, where the forecasting model is used as a trading signal to take long and short positions in CNH, performs particularly well.