Developing Foreign Bond Markets: The Arirang Bond Experience in Korea

This study investigates the development of Korea’s foreign bond (Arirang) market for won-denominated foreign bonds. We provide an institutional perspective and discuss the problems, concerns and key issues related to the development of this market. We find no evidence that Arirang issuance either crowded out local debt or had exchange rate implications. Overall, the Korean experience provides valuable lessons for other emerging nations seeking to build bond markets for local and foreign issuers. Instigating market development demands an enabling infrastructure, the nurturing of local and international demand and the deregulation of capital flows. This process is demanding, as the sophistication of the local bond market does not make it appealing to foreign borrowers per se.Arirang bonds; foreign bonds; bond market development

Arbitrage, Covered Interest Parity and Long-Term Dependence between the US Dollar and the Yen

Using a daily time series from 1983 to 2005 of currency prices in spot and forward USD/Yen markets and matching equivalent maturity short term US and Japanese interest rates, we investigate the sensitivity over the sample period of the difference between actual prices in forward markets to those calculated from short term interest rates. According to a fundamental theorem in financial economics termed covered interest parity (CIP) the actual and estimated prices should be identical once transaction and other costs are accommodated. The paper presents four important findings: First, we find evidence of considerable variation in CIP deviations from equilibrium that tends to be one way and favours those market participants with the ability to borrow US dollars (and subsequently lend yen). Second, these deviations have diminished significantly and by 2000 have been almost eliminated. We attribute this to the effects of electronic trading and pricing systems. Third, regression analysis reveals that interday negative changes in spot exchange rates, positive changes in US interest rates and negative changes in yen interest rates generally affect the deviation from CIP more than changes in interday volatility. Finally, the presence of long-term dependence in the CIP deviations over time is investigated to provide an insight into the equilibrium dynamics. Using a local Hurst exponent – a statistic used in fractal geometry - we find episodes of both positive and negative dependence over the various sample periods, which appear to be linked to episodes of dollar decline/yen appreciation, or vice versa. The presence of negative dependence is consistent with the actions of arbitrageurs successfully maintaining the long-term CIP equilibrium. Given the time varying nature of the deviations from equilibrium the sample period under investigation remains a critical issue when investigating the presence of longterm dependence.Hurst exponent; Efficient market hypothesis; covered interest parity, arbitrage

Volatility in the Gold Futures Market

We investigate the volatility structure of gold, trading as a futures contract on the Chicago Board of Trade (CBOT) using intraday (high frequency) data from January 1999 to December 2005. Apart from investigating the now familiar GARCH properties we also utilize a rarely used measure of volatility–the Garman Klass estimator – to provide new insights in intraday and interday volatility. This nonparametric measure incorporates the open, close, high and low price within a particular time interval. Both sets of results suggest significant variation across the trading day and week consistent with microstructure theories, although volatility is only slightly positively correlated with volume when measured by tick-count.Garman Klass estimator; volatility; gold; intraday patterns; futures

Credit Spread Dynamics: Evidence from Latin America

This paper examines the behaviour of credit spreads on key sovereign issuers from the Latin American region, which accounts for more than one third of international bond issues by developing, or emerging, markets. Since the late 1990s, credit spreads on Latin American issues have declined broadly inline with those in other emerging markets. Recent empirical analysis has explained this phenomenon by identifying critical macroeconomic factors, including the reduction in systematic risk in individual markets, although the structural models from the theoretical finance literature also predict the importance of key default and interest rate variables. This contribution adds to the understanding of these issues by investigating the application of structural models to the Latin American setting, one historically characterized by excessive volatility and susceptibility to episodes of default.credit spreads, long-run dynamics, Latin America, sovereign bonds, cointegration

A Pure Test for the Elasticity of Yield Spreads

The correlation between interest rates and corporate bond yield spreads is a well-known feature of structural bond pricing models. Duffee (1998) argues that this correlation is weak once the effects of call options are removed from the data; a conclusion that contradicts the negative correlation expected by Longstaff and Schwartz (1995). However, Elton et al. (2001) point out that Duffee's analysis ignores the effects of the tax differential between U.S. Treasury and corporate bonds. Canadian bonds have no such tax differential, yet, after controlling for callability, we find that the correlation between interest rates and corporate bond spreads remains negligible. We also find a significant negative relationship for callable bonds with this relationship increasing with the moneyness of the call provision. These results are robust under alternate empirical specifications.Bond Yield Spread, Default Risk, Callable Bonds, Corporate Bonds

Dynamic equilibrium correction modelling of yen Eurobond credit spreads

Understanding the long term relationship between the yields of risky and riskless bonds is a critical task for portfolio managers and policy makers. This study specifies an equilibrium correction model of the credit spreads between Japanese Government bonds (JGBs) and Japanese yen Eurobonds with high quality credit ratings. The empirical results indicate that the corporate bond yields are cointegrated with the otherwise equivalent JGB yields, with the spread defining the cointegration relation. In addition the results indicate that the equilibrium correction term is highly statistically significant in modelling credit spread changes. Another important factor is the risk-free interest rate with the negative sign, while there is little evidence of the contribution of the asset return to the behaviour of spreads.

Foreign Bond Markets and Financial Market Development: International Perspectives

The domestic bond markets of the Asia and Pacific region have grown considerably since the Asian financial crisis of 1997, although they remain undeveloped relative to the region's weight in the world economy. This paper proposes that in order to encourage further development of these markets, regulators should make them more accessible to foreign borrowers. To that end we offer insights into the nature and mechanics of foreign bond issuance by investigating the key characteristics of 3,132 foreign bonds issued in 14 countries (other than the United States) between July 1928 and June 2009. We found that the foreign borrowers that tap domestic markets are overwhelmingly of high credit quality and comprise sovereigns, supranationals, and major financial institutions. There is a preference for simple fixed-rate payment structures, which can then be swapped into the currency and coupon type of choice using currency and interest rate derivatives. On the whole, the long-term viability of foreign bond markets appears linked to the presence of highly liquid foreign exchange and derivatives markets that facilitate risk management and transformation, enabling regulation that facilitates cooperation with market participants, the presence of benchmark issues, and competitive pricing between alternate market segments.bond markets; financial market development; foreign bonds

Major Shareholders’ Trust and Market Risk: Substituting Weak Institutions with Trust

This study examines the impact of foreign controlling shareholder trust on firm market risk using the two measures of total and idiosyncratic risk. An extensive global sample of 12,496 firm-year observations from 43 countries is employed. The results show that firms controlled by foreign trusting shareholders display lower levels of risk in both market measures. Trust appears more important for firms based in countries with a less favourable institutional environment, whereby it varies with the investment horizon of foreign controlling shareholders. The results are robust after controlling for cultural measures, endogeneity, selection bias and alternative model specification