Japanese Interest Rates Swap Spread

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Japanese Interest RateSwap Spreads

Under Different MonetaryPolicy Regimes

TakayasuIto*

This paper investigates the determinants of Japanese interest rate swap spreads

by considering the differentmonetary policy regimes of the Bank of Japan (BOJ).

Four determinants of swap spreadscorporate bond spread, TED spread, slope

of yield curve, and volatilitywere chosen. When the monetary policy was

easing, swap spreads decreased as credit risk increased. When the monetary

policy was tightening,10-yearswap spread decreased in accordance with theincrease of corporate bond spread. TED spread contributed to swap spreads

positively in all maturities under tightening cycle of the monetary policy. Slope

of yield curve contributed more actively to the swap spreads in all maturities in

quantitative easing period and to the swap spreads of 5 years, 7 years and 10

years in tightening aspect. Volatility contributed more actively to the swap

spreads in all maturities in easingphase.

Introduction

This study investigates the determinants of Japanese interest rate

swap spreads in each subsample by considering different monetarypolicy regimes. Four determinants of swap spreadscorporate bondspread, TED spread, slope of yield curve, and volatilityare chosen.

The analysis of interest rate swap spreads is an interesting andimportant research topic, because swap spreads contain the price ofinterest rate swaps and market information. In Japan, interest rateswap transactions are used by financial institutions and corporations forrisk management. Financial institutions in Japan, especially banks,often use interest rate swap transactions for Asset-LiabilityManagement (ALM)-related operations.

An interest rate swap is an agreement between two parties to

exchange cash flows in the future. In a typical agreement, twocounterparties exchange streams of fixed and floating interest ratepayments. Thus, fixed interest rate payment can be transformed intofloating payment and vice versa. The amount of each floating ratepayment is based on a variable rate that has been mutually agreedupon by both the counterparties. For example, the floating ratepayment could be based on 6-month London Interbank Offer Rate(LIBOR).

The market for interest rate swaps has grown exponentially in the1990s. According to a survey by Bank for International Settlements(BIS), the notional outstanding volume of transactions of interest rateswaps amounted to $328,114 bn at the end of December 2008.1

Differences between swap rates and government bond yields of the


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Japanese Interest Rate Swap Spreads Under Different Monetary Policy Regimes

57

same maturity are referred to as swap spreads. If the swap andgovernment bond markets are efficiently priced, swap spreads mayreveal something about the perception of the systemic risk in thebanking sector.

* Faculty of Economics, Niigata University, 8050, Ikarashi, 2-no-cho, Nishi-ku,Niigata City, 950-2181, Japan

E-mail: ti [email protected]

1 Statistics are cited from Semiannual OTC derivatives statistics at end-December 2008. Atthe end ofDecember

2008, the notional outstanding volume of transactions of yen interest rate derivatives was$56,419 bn. For details,see Bank for International Settlements (2009).

2010 IUP. All Rights Reserved.
mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]


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The monetary policy changes tend to exert an impact on thefinancial markets. The asymmetric impacts of the monetary policy oninterest swap spreads are deduced by dividing the whole sample periodinto three periods depending on the monetary policy regimes. The first

period is from February 15, 1999 through August 11, 2000, duringwhich the Bank ofJapan (BOJ) adopted a zero interest rate policy tocounter deflationary pressure. The second period is from March 21,2001 through March 9, 2006, during which the BOJ introduced thequantitative easing policy under deflation caused by bad loan problemand weak domestic demand. The third period is from March 10, 2006through November 30, 2007. After the BOJ lifted the quantitativeeasing policy, they hiked uncollateralized call rate twice. In terms ofmonetary policy regimes, the first and second periods are easing, andthe third period tightening.

LiteratureReview

As 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), Duffieand 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 onswap quotations and bid-offer spreads by using quotations from twointerest rate swap dealers with different credit ratings (AAA and A). TheAAA offer rates are significantly higher than the A offer rates, and theAAA bid rates are significantly lower than the A bid rates. They alsodocument the relation between swap rates and par bond yieldsestimated from LIBOR and bid rate (LIBID) data. They identify some ofthe problems in testing the implications of swap pricing theory.

Duffie and Huang (1996) present a model for valuing claims subjectto default by both contracting parties, such as swaps and forwards.With counterparties of different default risk, the promised cash flows ofa swap are discounted by a switching discount rate that, at any givenstate and time, is equal to the discount rate of the counterparty forwhom the swap is currently out of the money (i.e., a liability). Theimpact of credit risk asymmetry and of netting is presented throughboth theory and numerical examples, which include interest rate and

currency swaps.

Brown et al. (1994) analyze the US swap spreads to find that (1) short-term, 1-year, and

3-year swaps are priced differently from the long-term, 5-year, 7-year,and 10-year swaps; and (2) the pricing dynamics for all the five swapmaturities changed substantially during the period spanning January1985 to May 1991. Cossin and Pirotte (1997) conduct empiricalanalysis on transaction data and show support for the presence of creditrisk in swap spreads. Credit ratings appear to be a significant factoraffecting swap spreads not only for their pooled sample but also forinterest rate swap, and currency swap separately as well. In interestrate swap, the credit rating impact on prices seems to come largely tothe detriment of the non-rated companies.


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Lang et al. (1998) argue that an interest rate swap, as a non-redundant security, creates surplus which will be shared by swapcounterparties to compensate their risks in swaps.

58 The IUP Journal of Applied Finance, Vol. 16, No. 1,

2010


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Analyzing the time series impacts of the changes of risks of swap

counterparties on swap spreads, they conclude that both lower and

higher rating bond spreads have positive impacts on swap spreads.

Lekkos and Milas (2001) assess the ability of the factors proposed inprevious research to account for the stochastic evolution of the term

structure of the US and the UK swap spreads. Using as factor proxies

the level, volatility, and slope of the zero-coupon government yield

curve as well as the Treasury-bill LIBOR spread and the corporate bond

spread, they identify a procyclical behavior for the short maturity US

swap spreads and a countercyclical behavior for longer maturity US

swap spreads. Liquidity and corporate bond spreads are also significant,

buttheir importance varies with maturity.

Minton (1997) directly tests the analogy between short-term swaps

and Eurodollar strips and finds that fair-value short-term swap rates

exist in the Eurodollar futures market. However, proxies fordifferential probability ofcounterparty default are statistically significant

determinantsofthe difference between OTC swap rates and swap rates

derived from Eurodollar futures prices for maturities of three and four

years.

Fehle (2003) analyzes 2-year and 5-year swap spreads in seven

countries (US, UK, Japan, Germany, France, Spain and the

Netherlands). He concludes that corporate bond spread, LIBOR spread,

and slope of yield curve are components of swap spreads.

Huang and Chen (2007) analyze the asymmetric impacts of various

economic shocks on swap spreads under distinct Fed monetary policy

regimes. The results indicate that (a) during theperiods ofaggressive

interest rate reductions, slope of the Treasury term structure accounts

for a sizeable share of the swap spread variance, although default shock

is also a major player; (b) on the other hand, liquidity premium is the

only contributor to the 2-year swap spread variance in monetary

tightening cycles; (c) the impact of default risk varies across both

monetary cycles and swap maturities; and (d) the effect of interest rate

volatility is generally more evident in loosening monetary regimes.

On the other hand, the number of previous studies analyzing themarket other than the US is small. Castagnetti (2004) analyzes theinterest rate swap spreads in Germany. Hamano (1997), Eom et al.

(2000) and Ito (2007) focus on the swap spreads in the Japanesemarket. Hamano (1997) focuses not on credit risk but on marketfactors like the TED spread, and finds that swap spreads reflect TEDspread and the long-term swap spreads are less influenced by TED

spread. On the other hand, Eom et al. (2000) focus on the credit riskand conclude that yen swap spread is significantly related to proxiesfor the long-term credit risk factor.

Ito (2007) investigates the determinants of interest rate swap

spreads in Japan. Four determinants of swap spreadsTED spread,

corporate bond spread, interest rate, and slope of yield curve fromJuly

12, 1995 through January 31, 2005are chosen. The swap spreads of

two years through four years are mostly influenced by TED spread,


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interest rate, and slope. While the swap spread of five years is mostly

decided by corporate bond spread and slope, the

swap spreads of seven years and ten years are mostly affected bycorporate bond spread.

Japanese Interest Rate Swap Spreads Under Different Monetary Policy Regimes 59


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The study by Huang and Chen (2007) is the only previous study

that considered the monetary policy regimes in the US market. The

present study is the first one to analyze interest rate swap spreads in

Japan under different monetary policy regimes.

Determinants ofSwap Spread

DefaultRisk

According to Brown et al. (1994), Minton (1997), Eom et al. (2000), and

Lekkos and Milas (2001), the default risk in swaps can be proxied with

the information from the corporate bond market. Any such proxy is

imperfect, as mentioned in the previous studies, because the

characteristics of the swap and corporate bond are not totally

comparable. Nevertheless, since swap default spreads areunobservable, the difference between the yield on a portfolio of

corporate bonds and the yield on an equivalent government bond can

be used as a proxy for the default premium.

LiquidityPremium

For instance, during periods of weak economy, treasury bonds are

considered more liquid, and swaps thus command a larger liquidity

premium. Liquidity effect may be absent in the aggregate data, but can

be arguably pronounced under certain market conditions. Brown et al.

(1994), Hamano (1997), Minton (1997), Eom et al. (2000) and Lekkos

and Milas (2001) check the influence of TED (LIBOR T-bill) spread .

Hamano (1997) finds that Japanese yen swap spreads are

influenced by TED and their influences get weaker as the maturities of

spread get longer from 1992 through 1996. On the other hand, Eom et

al. (2000) find that the influences of TED on Japanese swap spreads get

stronger as the maturities of spread get longer from 1990 through

1996.

Slope of Yield Curve andVolatility

Following the Sorensen and Bollier (1994) framework, in which the slope

ofthe term structure and interest rate volatility determine the value ofthe option to default, these two variables are incorporated into the

empirical model. It is notable that the impacts of the yield curve and

interest rate volatility on swap spreads may not be symmetrical under

various market conditions. For example, due to investors risk aversion,

risk premium may not necessarily be as responsive to the changes in

interest rate volatility during periods of little default risk.

Similarly, as Huang and Chen (2007) describe, swap spreads may be

more responsive to the shape of yield curve during periods of a steep

yield curve due to the flight to quality concern. Aggregating time

series data over different market conditions, therefore, produces results

that are in favor of finding no impact of economic shocks on swap


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spreads, because asymmetrical impacts may cancel out monetary

policy cycles. Eom et al. (2000) find that swap spreads are negatively

related to the slope of the term structure. Huang and Chen (2007) use

slope of yield curve and volatility. They calculate volatility of 2-year

US Treasury Note by

using EGARCHmodel.


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swap rates to decrease.4

2 The BOJ hiked the target of uncollateralized call rate from 0% to 0.25% on July 14, 2006 andfrom 0.25% to 0.5%

on February 21, 2007.3 JGBs are traded on a simple yield. Par rates are compounded yield.4 The extension of abolishing macro hedge accounting for another year promoted

receiving activity. It was abolished on March 31, 2003.



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Swa

p

Spr

ead

(%)

Swap

Spread

(%)

Swap

Spread

(%)

03/10/0

6 04/07/0

6 05/09/0

6 06/05/0

6 06/30/0

6 07/28/0

6 08/24/0

6 09/21/0

6 10/19/0

6 11/16/0

6 12/14/0

6 01/16/0

7 02/13/0

7 03/12/0

7 04/09/0

7 05/09/0

7 06/05/0

7 07/02/0

7 07/03/0

7

03/21/0

1 06/21/0

1 09/21/0

1 12/21/0

1 03/21/0

2 06/21/0

2 09/21/0

2 12/21/0

2 03/21/0

3 06/21/0

3 09/21/0

3 12/21/0

3 03/21/0

4 06/21/0

4 09/21/0

4 12/21/0

4 03/21/0

5 06/21/0

02/

15/9

9 03/

15/9

9 04/

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9 05/

15/9

9 06/

15/9

9 07/

15/9

9 08/

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9 09/

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9 10/

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9 11/

15/9

9 12/

15/9

9 01/

15/0

0 02/

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0 03/

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0 04/

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0 05/

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0 0 6 /

1 5 / 0

Figure 1: SwapSpreads

Sample A (From February 15, 1999 Through August 11,

2000)0.60

0.50

0.40

0.30

0.20

0.10

0.00

SS2

SS5

SS10

0.25

0.20

0.15

0.10

0.05

0.00

0.05

0.10

0.15

Sample B (From March 21, 2001 ThroughMarch 9, 2006)

SS2

SS5

SS10

Sample C (from March 10, 2006 Through November 30,2007)

0.35

0.30

0.25

0.20

0.150.10

0.05

0.00

SS2

SS5

SS10


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Table 1: Descriptive Statistics of Swap Spreads

Variable Averag SD Min. Max. Median

Whole Sample n = 2,167

SS2 0.108 0.049 0.014 0.307 0.094

SS5 0.105 0.077 0.086 0.328 0.102

SS7 0.107 0.100 0.129 0.423 0.090

SS10 0.123 0.144 0.101 0.554 0.081

Sample A n= 369

SS2 0.145 0.043 0.023 0.273 0.148

SS5 0.199 0.055 0.048 0.328 0.186

SS7 0.241 0.067 0.115 0.423 0.218

SS10 0.363 0.078 0.209 0.554 0.336

Sample B n = 1,370

SS2 0.081 0.024 0.014 0.148 0.081

SS5 0.061 0.052 0.086 0.195 0.071

SS7 0.048 0.064 0.129 0.205 0.066

SS10 0.040 0.083 0.101 0.330 0.030

Sample C n= 428

SS2 0.162 0.047 0.077 0.307 0.147

SS5 0.167 0.031 0.115 0.240 0.162

SS7 0.180 0.032 0.112 0.280 0.170

SS10 0.182 0.039 0.117 0.276 0.174

Note: Whole Sample=

February 15, 1999 through November 30, 2007.Sample A = from February 15, 1999 throughAugust 11, 2000. Sample B = from March 21,2001 through March 9, 2006. Sample C= fromMarch 10, 2006 through November 30, 2007. SS2= 2-year swap spread; SS5 = 5-year swapspread; SS7 = 7-year swap spread;SS10 = 10-year swap spread.

Table 2: Correlation of Swap Spreads

Variable SS SS SS SS1

Whole Sample

SS2 1.00

SS5 0.78 1.00

SS7 0.73 0.93 1.00

SS10 0.60 0.84 0.94 1.00

Sample A

SS2 1.000



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Table 2(Cont.)

Variable SS SS SS SS1

SS5 0.58 1.00

SS7 0.46 0.92 1.00

SS10 0.34 0.85 0.92 1.00

Sample B

SS2 1.00

SS5 0.71 1.00

SS7 0.50 0.81 1.00

SS10 0.34 0.59 0.89 1.00

Sample C

SS2 1.00

SS5 0.48 1.00

SS7 0.73 0.87 1.00

SS10 0.013 0.78 0.51 1.00

Note: Whole Sample = February 15, 1999 throughNovember 30, 2007.

Sample A = from February 15, 1999 throughAugust 11, 2000. Sample B = from March 21,2001 through March 9, 2006. Sample C= fromMarch 10, 2006 through November 30, 2007. SS2= 2-year swap spread; SS5 = 5-year swapspread;SS7 = 7-year swap spread; SS10 = 10-year swap spread.

Determinants ofSwap Spread

DefaultRisk

Default risk is defined as yield spread between 10-year corporate bondissued by the Tokyo Electric Power Company and 10-year JGB par yield.Corporate bond spread is considered to represent credit risk. In Japan,corporate bond market is illiquid. Thus, 10-year corporate bond issuedby the Tokyo Electric Company is the only data available for theanalysis. As for the data source, the period from February 15, 1999through July 23, 2007 is from Mitsubishi UFJ Securities. The period from

July 24, 2007 through November 30, 2007 is provided by JapanSecurities Dealers Association (JASDA).

LiquidityPremium

Liquidity premium is defined as TED spread between 6-month TIBORand 6-month TB (Treasury Bill). TIBOR is provided by the JapaneseBankers Association. TB yields are provided by the Mitsubishi UFJSecurities.

Slope of YieldCurve

Slope of yield curve is defined as the differential between 2-year and 10-year JGB par yields, as in Huang and Chen (2007).5 These par rates are


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provided by the Mitsubishi UFJ Securities.

5 2-year and 10-year US Treasury rates are used by Huang and Chen (2007).


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Volatility

Yield volatility calculated by EGARCH model is defined as volatility.6

The 2-year JGB par rates provided by the Mitsubishi UFJ Securities areused for the calculation, since Huang and Chen (2007) used the 2-yearUS Treasury Note for the calculation of EGARCH volatility.

Table 3 provides the descriptive statistics of determinants of swapspreads for the entire study period as well as for each subperiod.

Framework of Analysisand Results

Here, how to analyze the determinants of interest rate swap spread isexplained. OLS is used to estimate Equation (1). How explanatoryvariables are chosen is explained under the subhead

Table 3: Descriptive Statistics ofDeterminats of Swap Spreads

Variable Averag SD Min. Max. Median

WholeSample

CBS 0.117 0.044 0.027 0.278 0.107

TED 0.114 0.064 0.053 0.404 0.094

SLOPE 1.182 0.237 0.417 1.669 1.242

VOLA 0.033 0.050 0.000 0.836 0.018

SampleA

CBS 0.159 0.041 0.044 0.278 0.156

TED 0.157 0.073 0.023 0.404 0.123

SLOPE 1.408 0.115 1.151 1.669 1.401

VOLA 0.077 0.091 0.011 0.836 0.052

SampleB

CBS 0.101 0.039 0.027 0.205 0.091

TED 0.096 0.027 0.003 0.226 0.089

SLOPE 1.196 0.217 0.417 1.669 1.247

VOLA 0.014 0.020 0.000 0.143 0.005

SampleC

CBS 0.129 0.031 0.075 0.201 0.129

TED 0.133 0.104 0.053 0.353 0.108

SLOPE 0.942 0.141 0.712 1.298 0.891

VOLA 0.057 0.033 0.012 0.214 0.049

Note: Whole Sample = February 15, 1999 through November 30, 2007.Sample A = from February 15, 1999 throughAugust 11, 2000. Sample B = from March 21,2001 through March 9, 2006. Sample C= fromMarch 10, 2006 through November 30, 2008. CBS= Corporate Bond Spread; TED = TED Spread;

SLOPE=

Slope of Yield Curve; VOLA=

Volatility.


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6 See Nelson (1991) for EGARCH model.



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SS2 0.082 0.227 0.025 0.012 0.204

0.399

0.027(4.656)* ( (0.132) (2.026)* (1.916)*

SS5 0.147 0.695 0.872 0.035 0.9610.427

0.040(4.256)* ( ( (2.521)* (4.480)*

SS7 0.092 0.375 1.202 0.065 0.6740.292

0.047(1.885)* (1.835)* ( (3.983)* (2.262)*

0.007 0.007 0.958 0.073 1.0110.280

0.050(0.134) (0.032) ( (4.581)* (2.407)*

Determinants of Swap Spread. The serial correlations of t

are

adjusted using the method of Newey and West (1987). The lag periodsof 12 are used.7 First, analysis for the whole sample is conducted.Afterwards, analysis for each sample is conducted. Table 4 reports

these results.

Spreadt= +

1CBS

t+

2TED

t+

3SLOPE

t+

4VOLA

t+

t...(1)

CBS= Corporate Bond Spread, TED= TED Spread, SLOPE = Slope ofYield Curve,

Table 4: Results of Regression Analysis

1(CBS 2(TED 3(SLOP 4(VOL R2 SER

WholeSample

SS2 0.088 0.025 0.349 0.021 0.249

0.306

0.041(4.294)* (0.344) (4.857)* (1.492) (2.735)*

SS5 0.004 0.038 0.307 0.038 0.7500.378

0.061(0.133) (0.321) (3.392)* (2.188) (4.132)*

SS7 0.096 0.448 0.462 0.057 0.8970.490

0.071( (3.324)* (4.131)* (2.611)* (4.104)*

SS10 0.294 1.157 0.448 0.161 1.2170.579

0.093( (6.540)* (2.868)* (5.580)* (4.097)*

SampleA

SS2 0.259 0.766 0.120 0.023 0.084

0.540

0.029(2.738)* (5.054) ( (0.365) (

SS5 0.317 0.671 0.099 0.028 0.1550.351

0.045(2.419)* ( ( (0.377) (3.670)*

SS7 0.485 0.882 0.267 0.114 0.2000.413

0.052(3.634)* ( (1.700)* (1.561) (4.169)*

SS10 0.529 0.840 0.338 0.074 0.2470.394

0.061(3.096)* ( (1.685) ( (3.234)*

SampleB

SS10

7 As for the lag periods, the study has also checked 6 and 24 respectively. But the results arethe same as in the case of 12.



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Table 4(Cont.)

(CBS) (TED) (SLOPE) (VOLA) R2SER

1 2 3 4

SampleC

SS2 0.064 0.209 0.364 0.016 0.1280.703

0.026(1.660)* (1.410) (5.367)* (0.359) (1.022)

SS5 0.022 0.260 0.275 0.140 0.1640.322

0.026(0.540)* (1.520) (6.248)* (3.376)* (1.504)

SS7 0.071 0.108 0.292 0.075 0.2360.410

0.025(1.827)* (0.727) (7.193)* (1.814)

* (2.167)*

SS10 0.048 0.425 0.293 0.251 0.1660.516

0.027(0.048) ( (6.307)* (8.111)* (1.909)*

Note: Values in parentheses are t statistics.***, ** and * indicate significance at 1%, 5% and 10% levels respectively.

The serial correlations of errors are adjusted according to the method by Newey andWest (1987).Whole Sample = February 15, 1999 through November 30, 2007.Sample A = from February 15, 1999 through August 11, 2000.Sample B = from March 21, 2001 through March 9, 2006.Sample C= from March 10, 2006 through November 30, 2007.

VOLA = Volatility

First, analysis for the whole sample period is carried out. Corporatebond spread is positively related to swap spreads of 7 years and 10years. TED spread is positively related to swap spreads of 2 years, 5years, 7 years, and 10 years. Slope is positively correlated with swapspreads of 7 years and 10 years. Volatility is positively related toswap spreads of 2 years,5 years, 7 years, and 10 years.

According to Ito (2007), the swap spreads of 2 years through 4 years

are mostly influenced by TED spread, interest rate, and slope. Theswap spread of 5 years is mostly decided by corporate bond spreadand slope. The swap spreads of 7 years and 10 years are mostlyaffected by corporate bond spread. A complete comparison with Ito

(2007) is not possible because they analyzed swap spreads from July12, 1995 through January 31, 2005, and TED spread, corporate bondspread, interest rate, and the slope of yield curve are chosen as

determinants ofswap spreads.8 However, the results of this study aresimilar to those of Ito (2007), except for TED spread.

The size of the coefficient for TED spread gets larger as thematurity gets longer. This result is consistent with Eom et al. (2000).On the other hand, Hamano (1998) provides the opposite result thatthe coefficient of 10-year spread is the smallest.

Next, analysis on Sample A is conducted. Corporate bond spread isnegatively related to swap spreads in all maturities. TED spread isnegatively related to swap spreads of 2 years and

7 years. Slope is negatively related to 10-year swap spread. Volatility isnegatively related to


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8 Par rates of JGB used in this study are based on Adams and Van Deventer (1994),but par rates in Ito (2007) use the method of McCulloch (1975).



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2-year swap spread, but positively related to swap spreads of 5 years,7 years, and 10 years. These results indicate that the swap spreadsdecreased in accordance with the increase in corporate bond spread.Even though credit risk in the market increased, the active receiving in

fixed rates contributed to the decrease of swap rates. In other words,credit risk was not a component of swap spreads.

Next, analysis on Sample B is conducted. Corporate bond spreads arenegatively related to the swap spreads of 2 years, 5 years and 7years. TED spread is negatively related to swap spreads of 5 years, 7years and 10 years. Slope is positively related to swap spreads of 2years,

5 years, 7 years and 10 years. Volatility is positively related to swapspreads of 2 years, 5 years,7 years and 10years.

These results indicate that the swap spreads decreased inaccordance with the increase in corporate bond spread. Even thoughcredit risk in the market increased, the active receiving in fixed ratescontributed to the decrease of swap rates. In other words, credit riskwas not a component of swap spreads. The reason why slope ispositively related to swap spreads in all maturities is because themovement of slope is the largest in three samples. Even though thequantitative easing policy by the BOJ continued for five years, the JGByields and swap rates showed bumpy movement amid speculation inthe market that easing policy would be lifted soon. Thus, slope andvolatility are considered to have contributed to the swap spreads.

Finally, analysis on Sample C is conducted. Corporate bond spread isnegatively related to 10-year swap spread. TED spread is positivelyrelated to swap spreads of 2 years, 5 years,7 years, and 10 years. Slope is positively related to swap spreads of5years, 7 years and 10 years.Volatility is positively related to swap spreads of 7years and 10 years.

Conclusion

The present study investigates the determinants of Japanese interestrate swap spreads by considering the different monetary policyregimes of the BOJ. Four determinants of swap spreadscorporatebond spread, TED spread, slope of yield curve, and volatilityarechosen. The monetary policy changes tend to exert an impact on thefinancial markets. The asymmetric impact of the monetary policy onthe interest swap spreads is investigated by dividing the whole sampleperiod into three subperiods depending on the monetary policy regime.

First, analysis on the whole sample is conducted. Afterwards,analysis on each subsample is conducted. The most notable differencebetween the analysis on the whole sample and subsample is thecorporate bond spread. In the analysis pertaining to the whole sample,swap spreads of 7 years and 10 years are positively related to

corporate bond spread. This result indicates that market participants


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were conscious of credit risk, thus causing the widening of swapspreads when the bad loan problem of the Japanese banks drewattention.

On the other hand, analysis on each subsample shows that,especially when the monetary policy was easing, swap spreads

decreased as the credit risk increased. When the monetary policy wastightening, 10-year swap spread decreased in accordance with theincrease ofcorporate

bond spread. According to Huang and Chen (2007), the impact ofdefault risk varies across


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both monetary cycles and swap maturities. Specifically, default riskplays an important role in

2-year swap spreads during periods ofweak economic activities, which

correspond to loosening monetary regimes. On the contrary, it shows

minute effect during periods of increasing or stable interest rates. The

result of this study, that credit risk contributed to swap spreads

negatively in the easing period, is different from that of Huang and Chen

(2007).

Most of the study results are different from those of Huang and Chen

(2007). There are a couple of reasons to be considered. The market

structure of interest rate swap is different between Japan and the US.

The US swap market is structurally more close to derivatives market

of the US Treasury, whereas Japanese swap market is relatively

independent ofJapanese government bond market. They quote swap

rates as spreads to the US Treasury yield in the US, but they indicateswap rates as quotation inJapan.

As for the monetary policy regime in Japan, such easing periods as

the zero interest rate policy and the quantitative easing policy are very

special cases that the central bank has never taken. Future research

can analyze JGB and interest rate swap market from these points.

Acknowledgment: The author acknowledges the support received fromGrant-in Aid forScientificResearch

(KAKENHI 19530271) fromJSPS.

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Japanese Interest Rates Swap Spread

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