Price Discovery in China's Interest Rate Markets:Evidence from the Treasury Spot,Futures,and Interest Rate Swaps Markets
ZHANG Jinfan,TANG Yingwei,GANG Jianhua,FAN Linli
School of Management and Economics, Chinese University of Hong Kong Shenzhen, Shenzhen Finance Institute, International Monetary Institute, Renmin University of China; Shanghai Commercial Paper Exchange Corporation LTD; China Financial Policy Research Center, School of Finance, Renmin University of China; Zhengzhou Commodity Exchange
Summary:
An important aim of China's financial system reform is to develop direct finance and construct multiple-layer financial markets. The interest rate markets, including the Treasury bond spot market and interest rate derivative markets, play the role of determining the risk free interest rate in the economy. Because the risk free rate is essential for the valuation of all financial assets, the interest rate market provides the foundation for a sophisticated financial system. However, a malfunctioning interest rate market would create disorder in all of the other major financial markets. Given the central role of the interest rate markets, this paper examines the efficiency of these markets in terms of the timely incorporation of new information into the price. This paper focuses on three markets: the Treasury spot market, the Treasury futures market, and the interest rate swaps market. The prices in these three markets reflect the expectations on the future short-term risk-free rate formed in each individual market. If all of these markets are efficient, the prices should move together and simultaneously reflect new information. However, if there is friction in any of these markets, we would expect to detect heterogeneous price movements across the markets.We use the information share model and three-dimensional vector auto-regressive conditional heteroscedasticity model (VAR-MGARCH) to examine the information flow among different markets. This paper uses the 10-year futures contract prices, 5-year interest rate swap prices, and 10-year treasury bond spot prices as our research sample. These are the most liquid financial assets in their respective markets and therefore can best represent the information efficiency of these markets. Our data sample is of trading-day frerguehcy from March 20, 2015 to December 28, 2018. The sample contains 925 trading days in total.Using the information share model, we find that the interest rate swaps market and the futures market both lead the spot market in terms of price discovery. However, the interest rate swaps moderately outperform the futures market in the full sample. By dividing our sample into two subsamples according to time, we find that the information advantage of the derivatives markets over the spot market strengthens in the more recent period. Moreover, of the two derivatives markets, the futures market appears to grow faster than the swaps market. Although the swaps market dominates the futures market in terms of price discovery in the earlier period, the futures market becomes more advantageous in the more recent period.To corroborate our results, we further exploit the VAR model and the Granger causality test. The results show that the interest rate swap price directs both the futures price and the spot price of Treasury bonds in one direction, and the futures price also directs the spot price in one direction. These findings demonstrate that information flows from the derivatives markets to the spot market. Finally, we also use the VAR-MGARCH model to explore the transmission mechanism of the conditional variances among the markets. We find strong volatility interactions among the spot, futures, and interest rate swaps markets.The information advantage of the derivatives markets can be attributed not only to the higher leverage and easier short selling, but also to the investor structure. The major investors in China's Treasury bond spot market are big domestic commercial banks and insurance companies. These large institutional investors usually invest in Treasury bonds to meet their regulatory requirements or optimize their balance sheet structure, rather than to generate high trading profits. In contrast, the major players in the futures and interest rate swaps markets are mainly brokerage firms, investment banks, hedge funds, and sophisticated individual investors who actively explore the trading opportunities.Because the large institutional investors in the Treasury spot market do not trade actively, their information on the interest rate may not be incorporated into the spot market's prices immediately, which would weaken the price discovery process in this market. In the derivatives markets, the investors' hare much incentives to generate profits through active tradings, which strengthens the price discovery process in these markets.
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