Japanese Interest Rate Swap Spreads Under Different Monetary Policy Regimes

Takayasu Ito*
This paper investigates the determinants of Japanese interest rate swap spreads by considering the different monetary 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-year swap spread decreased in accordance with the increase 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 easing phase.

Introduct ion
This study investigates the determinants of Japanese interest rate swap spreads in each subsample by considering different monetary policy regimes. Four determinants of swap spreadscorporate bond spread, TED spread, slope of yield curve, and volatilityare chosen. The analysis of interest rate swap spreads is an interesting and important research topic, because swap spreads contain the price of interest rate swaps and market information. In Japan, interest rate swap transactions are used by financial institutions and corporations for risk management. Financial institutions in Japan, especially banks, often use interest rate swap transactions for Asset-Liability Management (ALM)-related operations. An interest rate swap is an agreement between two parties to exchange cash flows in the future. In a typical agreement, two counterparties exchange streams of fixed and floating interest rate payments. Thus, fixed interest rate payment can be transformed into floating payment and vice versa. The amount of each floating rate payment is based on a variable rate that has been mutually agreed upon by both the counterparties. For example, the floating rate payment could be based on 6-month London Interbank Offer Rate (LIBOR). The market for interest rate swaps has grown exponentially in the 1990s. According to a survey by Bank for International Settlements (BIS), the notional outstanding volume of transactions of interest rate swaps amounted to $328,114 bn at the end of December 2008.1 Differences between swap rates and government bond yields of the

same maturity are referred to as swap spreads. If the swap and government bond markets are efficiently priced, swap spreads may reveal something about the perception of the systemic risk in the banking sector.
* Faculty of Economics, Niigata Niigata City, 950-2181, Japan E-mail: ti to@e co n .nii ga ta-u .a c. jp
1

University, 8050, Ikarashi, 2-no-cho,

Nishi-ku,

Statistics are cited from Semiannual OTC derivatives statistics at end-December 2008. At the end of December 2008, the notional outstanding volume of transactions of yen interest rate derivatives was $56,419 bn. For details, see Bank for International Settlements (2009). Japanese Interest Rate Reserved. Swap Spreads Under Different Monetary Policy Regimes 2010 IUP. All Rights 57

The monetary policy changes tend to exert an impact on the financial markets. The asymmetric impacts of the monetary policy on interest swap spreads are deduced by dividing the whole sample period into three periods depending on the monetary policy regimes. The first period is from February 15, 1999 through August 11, 2000, during which the Bank of Japan (BOJ) adopted a zero interest rate policy to counter deflationary pressure. The second period is from March 21, 2001 through March 9, 2006, during which the BOJ introduced the quantitative easing policy under deflation caused by bad loan problem and weak domestic demand. The third period is from March 10, 2006 through November 30, 2007. After the BOJ lifted the quantitative easing policy, they hiked uncollateralized call rate twice. In terms of monetary policy regimes, the first and second periods are easing, and the third period tightening.

Literature Review
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), Duffie and 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 on swap quotations and bid-offer spreads by using quotations from two interest rate swap dealers with different credit ratings (AAA and A). The AAA offer rates are significantly higher than the A offer rates, and the AAA bid rates are significantly lower than the A bid rates. They also document the relation between swap rates and par bond yields estimated from LIBOR and bid rate (LIBID) data. They identify some of the problems in testing the implications of swap pricing theory. Duffie and Huang (1996) present a model for valuing claims subject to default by both contracting parties, such as swaps and forwards. With counterparties of different default risk, the promised cash flows of a swap are discounted by a switching discount rate that, at any given state and time, is equal to the discount rate of the counterparty for whom the swap is currently out of the money (i.e., a liability). The impact of credit risk asymmetry and of netting is presented through both theory and numerical examples, which include interest rate and currency swaps. Brown et al. (1994) analyze the US swap spreads to find that (1) shortterm, 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 swap maturities changed substantially during the period spanning January 1985 to May 1991. Cossin and Pirotte (1997) conduct empirical analysis on transaction data and show support for the presence of credit risk in swap spreads. Credit ratings appear to be a significant factor affecting swap spreads not only for their pooled sample but also for interest rate swap, and currency swap separately as well. In interest rate swap, the credit rating impact on prices seems to come largely to the detriment of the non-rated companies.

Lang et al. (1998) argue that an interest rate swap, as a nonredundant security, creates surplus which will be shared by swap counterparties to compensate their risks in swaps.
58 2010 The IUP Journal of Applied Finance, Vol. 16, No. 1,

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 in previous 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, but their 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 for differential probability of counterparty default are statistically significant determinants of the 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 the periods of aggressive 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 the market other than the US is small. Castagnetti (2004) analyzes the interest rate swap spreads in Germany. Hamano (1997), Eom et al. (2000) and Ito (2007) focus on the swap spreads in the Japanese market. Hamano (1997) focuses not on credit risk but on market factors like the TED spread, and finds that swap spreads reflect TED spread and the long-term swap spreads are less influenced by TED spread. On the other hand, Eom et al. (2000) focus on the credit risk and conclude that yen swap spread is significantly related to proxies for 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 from July 12, 1995 through January 31, 2005are chosen. The swap spreads of two years through four years are mostly influenced by TED spread,

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 by corporate bond spread.
Japanese Interest Rate Swap Spreads Under Different Monetary Policy Regimes 59

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 Swap Spread

Default Risk

of

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 are unobservable, 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.

Liquidity Premium
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 and Volatility

Following the Sorensen and Bollier (1994) framework, in which the slope of the term structure and interest rate volatility determine the value of the 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

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 EGARCH model.
60 2010 The IUP Journal of Applied Finance, Vol. 16, No. 1,

Dat a
A total of more than eight years of daily data, ranging from February 15, 1999 to November 30, 2007, is chosen. This data is provided by the Mitsubishi UFJ Securities. Three monetary policy regimes by the BOJ are chosen. The entire study period, February 15, 2000 through November 30, 2007, is divided into three subperiods based on the monetary policy regimes by the BOJ. The first period (Sample A) is from February 15, 1999 through August 11, 2000. The BOJ continued the zero interest rate policy during the first period. The second period (Sample B) is from March 21, 2001 through March 9, 2006. The BOJ continued the quantitative easing policy during the second period. The third period (Sample C) is from March 10, 2006 through November 30, 2007. The monetary policy was tightening after the BOJ announced the lifting of quantitative easing policy on March 9, 2006. Afterwards, the BOJ hiked uncollateralized call rate twice.2 The period from August 14, 2000 to March 19, 2001 was excluded from the analysis, since the daily sample is not long enough for the analysis. In terms of monetary policy, the first and the second periods are easing, but the third period is tightening. Variables for the analysis are defined as below.

Japanese Interest Swap Spread

Rate

Japanese interest rate swap rate minus Japanese government bond yield in the corresponding maturity is defined as swap spread. SS2 is 2year swap spread. SS5 is 5-year swap spread. SS7 is 7-year swap spread. SS10 is 10-year swap spread. As for Japanese government bond yield, par rates of Japanese Government Bond (JGB) are used.3 These par rates for the maturities of 2 years, 5 years, 7 years, and 10 years are calculated by the method mentioned in Adams and Van Deventer (1994) on a daily basis from February 15, 1999 through November 30, 2007. These par rates are provided by the Mitsubishi UFJ Securities. As for the Japanese interest rate swap market, rates of 2 years, 5 years, 7 years, and 10 years as of 3 p.m. at Tokyo time are used on a daily basis from February 15, 1999 to November 30, 2007. Bid rates and offer rates are indicated in the market. The swap rates, provided by the Mitsubishi UFJ Securities, are the averages of bid rates and offer rates. Figure 1 depicts the movements of swap spreads in 2 years, 5 years, and 10 years in each sample period. Table 1 provides the descriptive statistics of swap spreads for the entire study period as well as for each subperiod. Table 2 provides the correlation of swap spreads for the entire sample as well as for each sample period. In Sample B, swap spreads of 2 years, 5 years, 7 years, and 10 years sometimes became negative. In other words, swap rates sometimes were lower than JGB yields in all maturities. Especially, Japanese banks activated receiving in swap to increase profit, causing

swap rates to decrease.4

The BOJ hiked the target of uncollateralized call rate from 0% to 0.25% on July 14, 2006 and from 0.25% to 0.5% on February 21, 2007.
2 3 4

JGBs are traded on a simple yield. Par rates are compounded yield. The extension of abolishing macro hedge accounting for another year promoted receiving activity. It was abolished on March 31, 2003. 61

Japanese Interest Rate Swap Spreads Under Different Monetary Policy Regimes

62 2010

Swap Spread (%) Swap Spread (%) Swap Spread (%) 0.20 0.30 0.40 0.50 0.60 0.00 0.10 0.15 0.25 0.20 0.15 0.10 0.05 0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35

0.00 Sample B (From March 21, 2001 Through March 9, 2006) SS5 SS2 SS5 SS2 SS10 SS10 SS5 SS2 Sample C (from March 10, 2006 Through November 30, 2007)

0.05

0.10

Figure 1: Swap Spreads

Sample A (From February 15, 1999 Through August 11, 2000)

SS10

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

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 08/24/0 7 09/21/0 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 5 09/21/0 5 02/15/9 9 03/15/9 9 04/15/9 9 05/15/9 9 06/15/9 9 07/15/9 9 08/15/9 9 09/15/9 9 10/15/9 9 11/15/9 9 12/15/9 9 01/15/0 0 02/15/0 0 03/15/0 0 04/15/0 0 05/15/0 0 06/15/0 0 07/15/0

Table 1: Descriptive Statistics of Swap Spreads

Variable SS2 SS5 SS7 SS10 Sample A SS2 SS5 SS7 SS10 Sample B SS2 SS5 SS7 SS10 Sample C SS2 SS5 SS7 SS10
Note:

Averag SD e Whole Sample n = 2,167 0.108 0.105 0.107 0.123 n = 369 0.145 0.199 0.241 0.363 n = 1,370 0.081 0.061 0.048 0.040 n = 428 0.162 0.167 0.180 0.182 0.047 0.031 0.032 0.039 0.024 0.052 0.064 0.083 0.043 0.055 0.067 0.078 0.049 0.077 0.100 0.144

Min. 0.014 0.086 0.129 0.101 0.023 0.048 0.115 0.209 0.014 0.086 0.129 0.101 0.077 0.115 0.112 0.117

Max. 0.307 0.328 0.423 0.554 0.273 0.328 0.423 0.554 0.148 0.195 0.205 0.330 0.307 0.240 0.280 0.276

Median 0.094 0.102 0.090 0.081 0.148 0.186 0.218 0.336 0.081 0.071 0.066 0.030 0.147 0.162 0.170 0.174

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. SS2 = 2-year swap spread; SS5 = 5-year swap spread; SS7 = 7-year swap spread;SS10 = 10year swap spread.

Table 2: Correlation of Swap Spreads

Variable Whole Sample SS2 SS5 SS7 SS10 Sample A SS2 SS 2 1.00 0 0.78 6 0.73 5 0.60 0 1.000
63

SS 5

SS 7

SS1 0

1.00 0 0.93 7 0.84 5

1.00 0 0.94 0

1.00 0

Japanese Interest Rate Swap Spreads Under Different Monetary Policy Regimes

Table 2 (Cont.)
Variable SS5 SS7 SS10 Sample B SS2 SS5 SS7 SS10 Sample C SS2 SS5 SS7 SS10
Note:

SS 2 0.58 8 0.46 4 0.34 9 1.00 0 0.71 5 0.50 2 0.34 6 1.00 0 0.48 4 0.73 1 0.013

SS 5 1.00 0 0.92 6 0.85 4 1.00 0 0.81 6 0.59 4 1.00 0 0.87 5 0.78 2

SS 7 1.00 0 0.92 2

SS1 0

1.00 0

1.00 0 0.89 7

1.00 0

1.00 0 0.51 7

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. SS2 = 2-year swap spread; SS5 = 5-year swap spread; SS7 = 7-year swap spread; SS10 = 10-year swap spread.

1.00 0

Determinants Swap Spread

of

Default Risk Default risk is defined as yield spread between 10-year corporate bond issued 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 issued by the Tokyo Electric Company is the only data available for the analysis. As for the data source, the period from February 15, 1999 through July 23, 2007 is from Mitsubishi UFJ Securities. The period from July 24, 2007 through November 30, 2007 is provided by Japan Securities Dealers Association (JASDA). Liquidity Premium Liquidity premium is defined as TED spread between 6-month TIBOR and 6-month TB (Treasury Bill). TIBOR is provided by the Japanese Bankers Association. TB yields are provided by the Mitsubishi UFJ Securities. Slope of Yield Curve Slope of yield curve is defined as the differential between 2-year and 10year JGB par yields, as in Huang and Chen (2007).5 These par rates are

provided by the Mitsubishi UFJ Securities.

5

2-year and 10-year US Treasury rates are used by Huang and Chen (2007). The IUP Journal of Applied Finance, Vol. 16, No. 1,

64 2010

Volatil ity Yield volatility calculated by EGARCH model is defined as volatility.6 The 2-year JGB par rates provided by the Mitsubishi UFJ Securities are used for the calculation, since Huang and Chen (2007) used the 2-year US Treasury Note for the calculation of EGARCH volatility.
Table 3 provides the descriptive statistics of determinants of swap spreads for the entire study period as well as for each subperiod.

Framework of and Results

Analysis

Here, how to analyze the determinants of interest rate swap spread is explained. OLS is used to estimate Equation (1). How explanatory variables are chosen is explained under the subhead Table 3: Descriptive Statistics of Determinats of Swap Spreads
Variable Averag e 0.117 0.114 1.182 0.033 SD Whole Sample 0.044 0.064 0.237 0.050 Sample A CBS TED SLOPE VOLA 0.159 0.157 1.408 0.077 0.041 0.073 0.115 0.091 Sample B CBS TED SLOPE VOLA 0.101 0.096 1.196 0.014 0.039 0.027 0.217 0.020 Sample C CBS TED SLOPE VOLA
Note:

Min.

Max.

Median

CBS TED SLOPE VOLA

0.027 0.053 0.417 0.000

0.278 0.404 1.669 0.836

0.107 0.094 1.242 0.018

0.044 0.023 1.151 0.011

0.278 0.404 1.669 0.836

0.156 0.123 1.401 0.052

0.027 0.003 0.417 0.000

0.205 0.226 1.669 0.143

0.091 0.089 1.247 0.005

0.129 0.133 0.942 0.057

0.031 0.104 0.141 0.033

0.075 0.053 0.712 0.012

0.201 0.353 1.298 0.214

0.129 0.108 0.891 0.049

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, 2008. CBS = Corporate Bond Spread; TED = TED Spread; SLOPE = Slope of Yield Curve; VOLA = Volatility.

See Nelson (1991) for EGARCH model. 65

Japanese Interest Rate Swap Spreads Under Different Monetary Policy Regimes

Determinants of Swap Spread. The serial correlations of t are adjusted using the method of Newey and West (1987). The lag periods of 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 = + 1CBSt + 2TEDt + 3SLOPEt + 4VOLAt + t ...(1) CBS = Corporate Bond Spread, TED = TED Spread, SLOPE = Slope of Yield Curve, Table 4: Results of Regression Analysis
1( CBS
)

2( TED
)

3( SLOP 4(VOL
E) A)

R2

SER

Whole Sample

SS2 SS5 SS7 SS10

0.088 (4.294)* ** 0.004 (0.133) 0.096 ( 2.821)*** 0.294 ( 6.749)***

0.025 (0.344) 0.038 (0.321) 0.448 (3.324)* ** 1.157 (6.540)* ** 0.766

0.349

0.021

(4.857)* (1.492) ** 0.307 0.038 (3.392)* ** 0.462 (4.131)* ** 0.448 (2.188) 0.057 (2.611)* ** 0.161

SS2 SS5 SS7 SS10

0.259 (2.738)* ** 0.317 (2.419)* ** 0.485 (3.634)* ** 0.529 (3.096)* **

0.54 ( 0 2.716)*** 0.671 0.155 0.35 ( ( (0.377) (3.670)* 1 2.547)** 0.733)*** ** 0.882 0.267 0.114 0.200 0.41 ( (1.700)* (1.561) (4.169)* 3 2.720)*** ** 0.840 0.338 0.074 0.247 0.39 ( (1.685) ( (3.234)* 4 2.450)** Sample0.801)*** ** B (5.054) ( (0.365) 1.751)*** 0.099 0.028 0.227 0.025 0.012 (2.026)* * 0.035 (2.521)* * 0.065 (3.983)* ** 0.073 (4.581)* ** ( (0.132) 4.484)*** 0.695 0.872 ( ( 5.837)*** 2.446)** 0.375 1.202 (1.835)* ( 2.679)*** 0.007 0.958 (0.032) ( 2.014)** 0.39 (1.916)* 9 0.961 0.42 (4.480)* 7 ** 0.674 0.29 (2.262)* 2 * 1.011 0.28 (2.407)* 0 * 0.204

A 0.120

(2.868)* (5.580)* **Sample ** 0.023

0.30 (2.735)* 6 ** 0.750 0.37 (4.132)* 8 ** 0.897 0.49 (4.104)* 0 ** 1.217 0.57 (4.097)* 9 ** 0.084

0.249

0.04 1 0.06 1 0.07 1 0.09 3

0.02 9 0.04 5 0.05 2 0.06 1

SS2 SS5 SS7 SS10

0.082 (4.656)* ** 0.147 (4.256)* ** 0.092 (1.885)* 0.007 (0.134)

0.02 7 0.04 0 0.04 7 0.05 0

As for the lag periods, the study has also checked 6 and 24 respectively. But the results are the same as in the case of 12. 66 The IUP Journal of Applied Finance, Vol. 16, No. 1,

2010

Table 4 (Cont.)
(CBS) (TED) (SLOPE) (VOLA)
SER 1
2 3 4

R2

Sample C SS2 SS5 SS7 SS10

Note:

0.064 (1.660)* 0.022 (0.540)* ** 0.071 (1.827)* 0.048 (0.048)

0.209 (1.410) 0.260 (1.520) 0.108 (0.727) 0.425

0.364 (5.367)* ** 0.275 (6.248)* ** 0.292 (7.193)* ** 0.293

0.016 (0.359) 0.140 (3.376)* ** 0.075 (1.814)* 0.251 (8.111)* **

0.128 (1.022) 0.164 (1.504) 0.236

0.70 3 0.32 2

0.02 6 0.02 6 0.02 5 0.02 7

***, ** and * indicate significance at 1%, 5% and 10% levels respectively. The serial correlations of errors are adjusted according to the method by Newey and West (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.

( (6.307)* 2.321)** Values in parentheses are t ** statistics.

0.41 (2.167)* 0 * 0.166 0.51 (1.909)* 6

VOLA = Volatility First, analysis for the whole sample period is carried out. Corporate bond spread is positively related to swap spreads of 7 years and 10 years. TED spread is positively related to swap spreads of 2 years, 5 years, 7 years, and 10 years. Slope is positively correlated with swap spreads of 7 years and 10 years. Volatility is positively related to swap 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. The swap spread of 5 years is mostly decided by corporate bond spread and slope. The swap spreads of 7 years and 10 years are mostly affected by corporate bond spread. A complete comparison with Ito (2007) is not possible because they analyzed swap spreads from July 12, 1995 through January 31, 2005, and TED spread, corporate bond spread, interest rate, and the slope of yield curve are chosen as determinants of swap spreads.8 However, the results of this study are similar to those of Ito (2007), except for TED spread. The size of the coefficient for TED spread gets larger as the maturity gets longer. This result is consistent with Eom et al. (2000). On the other hand, Hamano (1998) provides the opposite result that the coefficient of 10-year spread is the smallest. Next, analysis on Sample A is conducted. Corporate bond spread is negatively related to swap spreads in all maturities. TED spread is negatively related to swap spreads of 2 years and 7 years. Slope is negatively related to 10-year swap spread. Volatility is negatively related to

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). 67

Japanese Interest Rate Swap Spreads Under Different Monetary Policy Regimes

2-year swap spread, but positively related to swap spreads of 5 years, 7 years, and 10 years. These results indicate that the swap spreads decreased 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 are negatively related to the swap spreads of 2 years, 5 years and 7 years. TED spread is negatively related to swap spreads of 5 years, 7 years and 10 years. Slope is positively related to swap spreads of 2 years, 5 years, 7 years and 10 years. Volatility is positively related to swap spreads of 2 years, 5 years, 7 years and 10 years. These results indicate that the swap spreads decreased 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. The reason why slope is positively related to swap spreads in all maturities is because the movement of slope is the largest in three samples. Even though the quantitative easing policy by the BOJ continued for five years, the JGB yields and swap rates showed bumpy movement amid speculation in the market that easing policy would be lifted soon. Thus, slope and volatility are considered to have contributed to the swap spreads. Finally, analysis on Sample C is conducted. Corporate bond spread is negatively related to 10-year swap spread. TED spread is positively related to swap spreads of 2 years, 5 years, 7 years, and 10 years. Slope is positively related to swap spreads of 5 years, 7 years and 10 years. Volatility is positively related to swap spreads of 7 years and 10 years.

Conclus ion
The present study investigates the determinants of Japanese interest rate swap spreads by considering the different monetary policy regimes of the BOJ. Four determinants of swap spreadscorporate bond spread, TED spread, slope of yield curve, and volatilityare chosen. The monetary policy changes tend to exert an impact on the financial markets. The asymmetric impact of the monetary policy on the interest swap spreads is investigated by dividing the whole sample period 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 difference between the analysis on the whole sample and subsample is the corporate 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

were conscious of credit risk, thus causing the widening of swap spreads when the bad loan problem of the Japanese banks drew attention. 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 was tightening, 10-year swap spread decreased in accordance with the increase of corporate bond spread. According to Huang and Chen (2007), the impact of default risk varies across
68 2010 The IUP Journal of Applied Finance, Vol. 16, No. 1,

both monetary cycles and swap maturities. Specifically, default risk plays an important role in 2-year swap spreads during periods of weak 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 of Japanese government bond market. They quote swap rates as spreads to the US Treasury yield in the US, but they indicate swap rates as quotation in Japan. 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 from Grant-in Aid for Scientific Research (KAKENHI 19530271) from JSPS.

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