Japanese Interest Rate Swap Spreads under Different Monetary Policy Regimes (2010)

(ProQuest: ... denotes formula omitted.)IntroductionThis study investigates the determinants of Japanese interest rate swap spreads in each subsample by considering different monetary policy regimes. Four determinants of swap spreads-corporate bond spread, TED spread, slope of yield curve, and volatility-are chosen. The analysis of interest rate swap spreads is an interesting and important research topic, because swap spreads contain the price of interest rate swaps and market information. In Japan, interest rate swap transactions are used by financial institutions and corporations for risk management. Financial institutions in Japan, especially banks, often use interest rate swap transactions for Asset-Liability Management (ALM)-related operations.An interest rate swap is an agreement between two parties to exchange cash flows in the future. In a typical agreement, two counterparties exchange streams of fixed and floating interest rate payments. Thus, fixed interest rate payment can be transformed into floating payment and vice versa. The amount of each floating rate payment is based on a variable rate that has been mutually agreed upon by both the counterparties. For example, the floating rate payment could be based on 6-month London Interbank Offer Rate (LIBOR).The market for interest rate swaps has grown exponentially in the 1990s. According to a survey by Bank for International Settlements (BIS), the notional outstanding volume of transactions of interest rate swaps amounted to $328,114 bn at the end of December 2008.1 Differences between swap rates and government bond yields of the same maturity are referred to as swap spreads. If the swap and government bond markets are efficiently priced, swap spreads may reveal something about the perception of the systemic risk in the banking sector.The monetary policy changes tend to exert an impact on the financial markets. The asymmetric impacts of the monetary policy on interest swap spreads are deduced by dividing the whole sample period into three periods depending on the monetary policy regimes. The first period is from February 15, 1999 through August 11, 2000, during which the Bank of Japan (BOJ) adopted a zero interest rate policy to counter deflationary pressure. The second period is from March 21, 2001 through March 9, 2006, during which the BOJ introduced the quantitative easing policy under deflation caused by bad loan problem and weak domestic demand. The third period is from March 10, 2006 through November 30, 2007. After the BOJ lifted the quantitative easing policy, they hiked uncollateralized call rate twice. In terms of monetary policy regimes, the first and second periods are easing, and the third period tightening.Literature ReviewAs for the analysis of the interest rate swap spreads in the US market, previous studies such as Sun et al. (1993), Brown et al. (1994), Duffie and Huang (1996), Cossin and Pirotte (1997), Minton (1997), Lang et al. (1998), Lekkos and Milas (2001), Fehle (2003) and Huang and Chen (2007) can be cited.Sun et al. (1993) examine the effect of dealers' credit reputations on swap quotations and bid-offer spreads by using quotations from two interest rate swap dealers with different credit ratings (AAA and A). The AAA offer rates are significantly higher than the A offer rates, and the AAA bid rates are significantly lower than the A bid rates. They also document the relation between swap rates and par bond yields estimated from LIBOR and bid rate (LIBID) data. They identify some of the problems in testing the implications of swap pricing theory.Duffie and Huang (1996) present a model for valuing claims subject to default by both contracting parties, such as swaps and forwards. With counterparties of different default risk, the promised cash flows of a swap are discounted by a switching discount rate that, at any given state and time, is equal to the discount rate of the counterparty for whom the swap is currently out of the money (i. …