Three Japan Premiums in Autumn 1997 and Autumn 1998 -- Why did premiums differ between markets? --

This paper analyzes developments in the Japan premium in three markets - the dollar market, the yen market, and the dollar/yen swap market - in the autumn of both 1997 and 1998, when concern increased with respect to the creditworthiness of Japanese banks. Among the three Japan premiums, the relationship that "the Japan premium in the dollar currency market = the Japan premium in the yen currency market + the Japan premium in the dollar/yen swap market" generally holds. However, in the autumn of both 1997 and 1998, there were times when this relationship did not hold. Possible reasons for the divergence of the swap rate from the theoretical value derived from its underlying assets (dollar interest rate, yen interest rate, dollar/yen spot rate) are two-fold: First, the price of underlying assets might not fully reflect risk premium implicitly existing in the market. Second, the widening of the information gap (asymmetry) concerning the creditworthiness of Japanese banks among market participants could have a bearing. The results support the possibility of both. When information concerning the creditworthiness of domestic banks in foreign and domestic markets widens, the foreign exchange swap market may function more as a foreign currency funding market than the foreign currency cash market. Based on these understandings, it is important to carefully monitor the foreign exchange swap market as well as to make efforts to improve its functioning. Information gaps between domestic and foreign market participants should be narrowed in order to reduce risk premium attached to the foreign currency funding cost of domestic banks.