Financial Market Functioning and Monetary Policy: Japanfs Experience

This paper reviews the financial market functioning under the zero interest rate policy (ZIRP) and the subsequent quantitative monetary easing policy (QMEP) conducted by the Bank of Japan (BOJ). First, the estimation results of the Japanese government bond yield curve using the Black-Gorovoi-Linetsky (BGL) model show that (1) the shadow interest rate has been negative since the late 1990s, turned upward in 2003, and has been on an uptrend since then, and (2) the first-hitting time until the negative shadow interest rate hits zero again under the risk-neutral probability is estimated to be about three months as of the end of February 2006. Second, under the ZIRP and QMEP, the risk premiums for Japanese banks have almost disappeared in short-term money markets such as the market for negotiable certificates of deposit, while they have remained in the credit default swap market and the stock market. This result supports the view that market participants have positively perceived the BOJfs ample liquidity provisions in containing the near- term defaults of banks caused by the liquidity shortage.Bank of Japan; Term structure of interest rates; Zero lower bound; Zero interest rates; Quantitative monetary easing policy; Bank risk premium

Exploring the Role of Money in Asset Pricing in Japan: Monetary Considerations and Stochastic Discount Factors

As emphasized by Giovannini and Labadie (1991), empirical regularities involving nominal interest rates, asset prices, and inflation should be ultimately determined by money. The role of money, however, is almost neglected, particularly in terms of asset-pricing literature. This paper attempts to investigate the role of money in asset pricing in Japan. Specifically, it compares the empirical performance of stochastic discount factors derived from (i) the standard C-CAPM, (ii) the habit formation model, (iii) the money-in-the-utility model, and (iv) the cash-in-advance model. Empirical results show that in terms of the underlying parameters estimated by Hansen's (1982) Generalized Method of Moments (GMM), the habit formation and the cash-in-advance models are almost always rejected, although no significant difference is found in terms of the volatility bound test among models. The specification test between the standard C-CAPM and the money-in-the-utility model generally favors the latter, implying that there is a positive role of money in specifying the stochastic discount factor.

Optimal Timing in Banks' Write-Off Decisions under the Possible Implementation of a Subsidy Scheme: A Real Options Approach

This paper provides a formal model that investigates optimal timing in banks' writing off their nonperforming loans. The motivation comes from the recent episodes of Japanese banks, which have been slow to clean up their nonperforming loans after the collapse of the "bubble" economy in the early 1990s. A real options approach is employed to measure the value of the rationality of the "forbearance policy." It is assumed that uncertainty will arise from the following sources: (1) the reinvestment return from freeing up funds through write-offs; (2) liquidation losses; (3) the possible implementation of a subsidy scheme; and (4) the reputational repercussions from not immediately writing off their nonperforming loans. This paper attaches particular importance to the uncertainty from the possible implementation of the subsidy scheme to explore its desirable features. Also, this paper examines the possible role of monetary policy in boosting the banks' incentive to write off.

Uncertainty, Monitoring Costs, and Private Banks' Lending Decisions in a Duopolistic Loan Market: A Game-Theoretic Real Options Approach

This paper explores banks' entry decisions into a duopolistic loan market to shed light on the prolonged slump in the Japanese loan market in the 1990s. The game-theoretic real options approach is employed to analyze the effects of uncertainty on lending decisions. Special emphasis is given to the differences resulting from the alternative assumptions regarding whether the roles of leader and follower are interchangeable or predetermined. The theoretical model shows that when the roles are predetermined as in the case of the Japanese main bank system, both leader and follower banks have a greater incentive to wait until the loan demand condition improves sufficiently than when the roles are interchangeable. The numerical analysis shows that a rise in the demand volatility raises threshold values of current demand, which raises the incentive to wait for both leader and follower banks. In contrast, the direction of the effect of a change in the expected growth rate of demand depends on the assumptions regarding which parameter is adjustable, the risk-adjusted discount rate, or the dividend rate. The effects of a change in the probability of bankruptcy of a borrowing firm and the interest rate elasticity of loan demand are also examined.

Testing the Ex Ante Relationship between Asset and Investment Returns in Japan: An Application of the P-CAPM to Japanese Asset Returns

This article provides an empirical investigation into the validity of the production-based capital asset-pricing model (P-CAPM) in the Japanese asset markets during the period 1980-97. Several methodologies are used to test the P-CAPM, which include the generalized method of moments (GMM) test of the Euler equations, the volatility bound test, the mispricing test, and the test of the ability of stock and investment returns to forecast future economic activity. The empirical results basically support the P-CAPM. For example, the GMM test of the Euler equations strongly favors the P-CAPM in terms of the statistical significance level of the estimated parameter and the overidentification test. In addition, statistical inference of the volatility bound test cannot significantly reject the P-CAPM. On the other hand, the estimation result of the mispricing coefficients suggests that the so-called risk- free rate puzzle is a more significant phenomenon than the so-called equity premium puzzle in Japan during this period.

Markup Pricing and Monetary Policy: A Reexamination of the Effectiveness of Monetary Policy under Imperfect Competition

If markup ratios fluctuate widely, so does output volume and investment. This magnifies the business cycle and increases uncertainty about future economic conditions. This paper investigates the implication for monetary policy by analyzing markup ratios. The main conclusions are (1) as a result of the failure of Japanese firms to fully adjust their prices to exogenous shocks, markup ratios sometimes greatly deviate from trend lines. (2) According to the menu-cost theorem, the existence of costs associated with price changes prevents firms from changing prices to the level consistent with marginal costs, thus reducing social welfare. In this regard, establishing a money supply rule under which monetary authorities accommodate exogenous shocks provides an incentive for firms to change their prices. (3) Markup pricing magnifies the social welfare cost of inflation. In this argument, monetary authorities have the optimal choice of tightening monetary policy even under low inflation, if they observe that markup ratios have remained high.

Extracting market expectations from yield curves augmented by money market interest rates: the case of Japan

This paper attempts to extract market expectations about the Japanese economy and the BOJ’s policy stance from the yen yield curves augmented by money market interest rates, during the period from the end of the quantitative easing policy in March 2006. We use (i) the swap yield curves augmented by OIS interest rates (OIS/Swap), and (ii) the JGB yield curve augmented by FB/TB interest rates. First, using the Nelson-Siegel [1987] model, we estimate three latent dynamic factors, which can be interpreted as reflecting market expectations. Second, we investigate the relative importance of price discovery for each factor between OIS/Swap and FBTB/JGB, and find that the former has a more dominant role of price discovery for all factors. Third, we estimate the efficient price for each factor common to both yield curves using a time-series structural model, which enables us to decompose each factor into the efficient price and idiosyncratic factor. JEL Classification: E43, E52, G12overnight index swap, price discovery, structural time-series model, swap spread, yield curve

Price Discovery of Credit Spreads for Japanese Mega-Banks: Subordinated Bond and CDS

This paper empirically investigates the determinants of credit spreads for Japanese mega-banks with emphasis on comparing subordinated CDS spreads with the subordinated bond spreads from the viewpoint of price discovery in both credit markets. The main findings are summarized as follows. First, subordinated CDS and subordinated bond spreads are significantly cointegrated for most banks, and price discovery measures suggest that the CDS spread plays a more dominant role in price discovery than the bond spread. Second, although both CDS and bond spreads significantly react to the Japanese sovereign CDS spread, only the CDS spread reacts significantly to other financial market variables including its own volatility and equity return. Third, both spreads are responsive to the changes in fundamental accounting variables such as the capital? asset ratio and the nonperforming loan ratio. These accounting variables are likely to constitute common factors that are behind the cointegration relationship. Last, significant volatility spillovers are detected from the CDS to bond spreads. This result implies that new information flows more in this direction.Subordinated Bond, Credit Default Swap, Japanese Banks, Price Discovery, Volatility Spillover, Bivariate GARCH

Optimal Timing in Trading Japanese Equity Mutual Funds: Theory and Evidence

This paper provides both theoretical and empirical analyses of market participants' optimal decision-making in trading Japanese equity mutual funds. First, we build an intertemporal decision-making model under uncertainty in the presence of transaction costs. This setting enables us to shed light on the investors' option to delay investment. A comparative analysis shows that an increase in uncertainty over the expected rate of return on mutual funds has a negative impact not only on market participants' buying behavior but also on their selling behavior. In addition, a several percent increase in front-end loads and redemption fees is likely to change the optimal holding ratio of mutual funds in investors' portfolios, by up to 10 percent. Second, we empirically examine the theoretical implications using daily transaction data of selected equity mutual funds in Japan. By estimating a panel data model, we conclude that for the sample period, from August 2000 to July 2001, investment behavior has been rational in light of our theoretical model. Our results suggest that investors are likely to rationally postpone their purchases of equity mutual funds under the present circumstances of low expected returns, high degree of uncertainty, and high trading costs.

The Japanese Repo Market: Theory and Evidence

Repurchase agreement (repo) transactions are widely used as a risk-free means of borrowing or lending funds and securities. Repo transactions can be categorized into (1) general collateral (GC) repos that borrow or lend funds, and (2) special collateral (SC) repos that borrow or lend specific securities. GC repo rates are priced at a level close to the risk-free interest rate, while SC repo rates are often priced far below the GC repo rates. This paper aims to examine the pricing mechanism of the Japanese repo market from both theoretical and empirical perspectives. First, Duffie (1996) and Krishnamurthy (2001) show that (1) equilibrium in the repo market requires no-arbitrage profits from combining repo and cash bond transactions, (2) the equilibrium level of repo spreads between GC and SC repo rates is determined at the point where the supply and demand curves of the underlying bond issues intersect in the repo market, and (3) expected returns from future matched book trading are reflected in the cash prices of SC bond issues. Second, the paper empirically examines the above theoretical implications using the data of repo rates and government bond prices in Japan. Our empirical results show that, regarding the on-the- run and the cheapest-to-deliver (CTD) issues, the above no-arbitrage condition is significantly satisfied.