Coupon Effects and the Pricing of Japanese Government Bonds an Empirical Analysis

In many markets, the term structure of interest rates implied by coupon Treasury bonds provides a key input for pricing and hedging interest rate-sensitive securities. Previous studies in the Japanese market, however, suggest that the prices of the Japanese Government Bonds (JGB's) were significantly affected by regulatory and liquidity factors. Consequently, it has been argued that term structure modelling in the Japanese context based on interest rate factors could lead to misleading results. Since the previous studies, there have been significant structural changes in the regulatory environment, and in the liquidity of the Japanese bond market in the 1990's. In this light, we examine the effect of these changes on the JGB prices during the period between 1990 and 1996 by analyzing the term structure of interest rates in the JGB market over time. Specifically, we use the B-spline method to fit the term structure of interest rates using weekly prices of quot;non-benchmarkquot; ten-year JGB's. We also use a non-linear econometric model to examine the significance of the quot;couponquot; effects, which are the results of regulatory, accounting and liquidity factors.Our empirical analysis shows that it is possible to closely fit the term structure of interest rates in the JGB market, with fitted price errors only slightly larger than those found in similar studies of the U.S. Treasury bond market. Furthermore, the fitted price errors diminish over our sample period, suggesting that the effect of non-present value factors became somewhat muted over time. Our empirical results also indicate that the coupon of a bond in the JGB market has a highly nonlinear effect on the prices due to the quot;par-bondquot; effect and the quot;high-couponquot; effect, although the quot;par-bondquot; effect is more pronounced in the recent period. Further analysis shows that three factors (level, slope and curvature) explain a substantial proportion of the variation in the JGB spot rates, as in the case of the U.S. Treasury market. Overall, these results indicate that the efficiency of the JGB markets has improved over time. Hence, the time-series movement of the JGB's can be captured to a substantial degree by common interest rate factors, although care should be taken to incorporate the special characteristics of individual bonds