The Japanese Repo Market: Theory and Evidence

Naohiko Baba and Yasunari Inamura

Repurchase agreement (repo) transactions are widely used as a risk-free means of borrowing or lending funds and securities. Repo transactions can be categorized into (1) general collateral (GC) repos that borrow or lend funds, and (2) special collateral (SC) repos that borrow or lend specific securities. GC repo rates are priced at a level close to the risk-free interest rate, while SC repo rates are often priced far below the GC repo rates. This paper aims to examine the pricing mechanism of the Japanese repo market from both theoretical and empirical perspectives.
First, Duffie (1996) and Krishnamurthy (2001) show that (1) equilibrium in the repo market requires no-arbitrage profits from combining repo and cash bond transactions, (2) the equilibrium level of repo spreads between GC and SC repo rates is determined at the point where the supply and demand curves of the underlying bond issues intersect in the repo market, and (3) expected returns from future matched book trading are reflected in the cash prices of SC bond issues.
Second, the paper empirically examines the above theoretical implications using the data of repo rates and government bond prices in Japan. Our empirical results show that, regarding the on-the-run and the cheapest-to-deliver (CTD) issues, the above no-arbitrage condition is significantly satisfied.

Key words: Repo; Government bond; No-arbitrage condition; Repo spread; On-the-run issues; Cheapest to deliver (CTD); Short sales

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