Pricing of Japanese Government Bonds: Influence of Futures Prices, Repo Rates, and Supply-Demand Conditions of Specific Issues

The levels of long-term interest rates are determined by the daily movements in the government securities market. In order to understand the mechanics of how government securities are priced and how such prices would fluctuate, it is important to examine, for example, the arbitrage between cash, futures and repo markets, and the supply and demand for each issue of government securities. Turning to the Japanese Government Bond (JGB) market, the market has become the largest government bond market in the world in terms of amounts outstanding. Nevertheless, there seems to be latitude for further improvements, including market liquidity. This issue of Market Review will look into one instance when problems surfaced, in the summer of 1999. At that time, the prices observed in the futures and cash markets--where any differences are expected to be quickly arbitraged away-- deviated considerably as uncertainty over Y2K mounted in Japanese markets. The differences reached unprecedented levels. The focus will be on the deterioration of arbitrage functions, distortions in the yield curve, and lower market liquidity, all of which affected the pricing of JGB's.