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THE CHINESE INTERBANK

REPO MARKET: AN

ANALYSIS OF TERM

PREMIUMS

LONGZHEN FAN

CHU ZHANG*

Because of the lack of short-term government bonds, the interbank repomarket in China has been providing the best information about market-driven short-term interest rates since its inception. This article examinesthe behavior of the repo rates of various terms and their term premiums.The work in this article supplements the study by F. Longstaff (2000),which reports supportive evidence for the pure expectations hypothesis

over the short range of the term structure with the use of repo data fromthe United States. It is found that the pure expectations hypothesis is sta-tistically rejected, although the term premiums are economically small. Itis shown that the short-term repo rate, repo rate volatility, repo marketliquidity, and repo rate spreads are all important in determining the termpremiums. 2006 Wiley Periodicals, Inc. Jrl Fut Mark 26:153167, 2006

The authors would like to thank Bob Webb (the Editor) and an anonymous referee for their helpfulcomments and suggestions. Longzhen Fan acknowledges the financial support from National ScienceFoundation of China Grant No. NSFC-70471010. Chu Zhang acknowledges financial support fromDirect Allocation Grant No. DAG02/03.BM23 of HKUST. All remaining errors are the authors.*Correspondence author, Department of Finance, Hong Kong University of Science and Technology,

Clear Water Bay, Kowloon, Hong Kong; e-mail: [email protected]

Received October 2004; Accepted May 2005

I Longzhen Fan is an Associate Professor in the Department of Finance at FudanUniversity in Shanghai, China.

I Chu Zhang is an Associate Professor in the Department of Finance at Hong KongUniversity of Science and Technology in Hong Kong.

The Journal of Futures Markets, Vol. 26, No. 2, 153167 (2006)

2006 Wiley Periodicals, Inc.

Published online in Wiley InterScience (www.interscience.wiley.com).

DOI: 10.1002/fut.20191

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Journal of Futures Markets DOI: 10.1002/fut

154 Fan and Zhang

INTRODUCTION

This article studies the interest-rate behavior in the Chinese interbank

repo market. A repo transaction is a pair of spot and forward transactions

of some securities in form, but short-term borrowing and lending with col-lateral in essence. In spite of its short history, the interbank repo market

in China has grown rapidly, taking over the interbank market for borrow-

ing and lending without collateral as the major form of interbank transac-

tions. The repo market facilitates borrowing and lending with enhanced

safety and plays a very important role in all businesses, including the stock

market and commodity futures markets.

The repo market in China is also important for another reason.

Because the Chinese government does not issue short-term bonds, the

repo rates become the only close substitutes of the benchmark risk-free

rates in the market, better than the Chinese interbank-offered rates(CHIBOR) because CHIBOR contain credit premiums. Although the

central government has tight control of the bank deposit rates, the inter-

bank repo rates do fluctuate according to the conditions of demand and

supply as billions of Renminbi (RMB, the Chinese currency) change

hands on the daily basis. The question is how interest rates of various

maturities at a given time reflect the expectations of the market partici-

pants about future interest-rate changes. In accordance with the litera-

ture, this question is examined in the context of testing the so-called

pure expectations hypothesis. This hypothesis basically states that the

term structure of interest rates at any given time is set such that theexpected return on rolling over short-term risk-free investments is

the same as the corresponding long-term risk-free rate. Although the

hypothesis has been tested repeatedly and rejected frequently in many

markets, the interest in reexamining it has never abated. Much has been

learned about the determination of interest rates in the process. Term

premiums, that is, longer-term rates in excess of what the pure expecta-

tions hypothesis predicts, and their determinants have been the most

important concept in decisions related to fixed-income investments. A

particularly relevant work by Longstaff (2000) documents that the pure

expectations hypothesis is supported in the U.S. repo market, in contrastwith the findings based on the U.S. Treasury market.

The results show that term premiums in the Chinese repo market

are positive and increasing with the term. The pure expectations hypothe-

sis is statistically rejected. However, the magnitude of the term premi-

ums is economically small relative to that found in the U.S. Treasury

market and elsewhere. The finding in Longstaff (2000) that the U.S.

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The Chinese Interbank Repo Market 155


repo rates conform to the pure expectations hypothesis, though not strictly

observed in the Chinese interbank repo market, indeed has some merit

for repo markets outside the United States. The term premiums are

related to the short-term repo rate, to term spreads, to the trading

volumes of repo markets, and to the volatility of the repo rates. Allthese variables contribute to the determination of term premiums, as

the liquidity preference hypothesis, a classical alternative theory to the

expectations hypothesis, predicts.

The article is organized as follows. The Chinese interbank repo

market is described. The unconditional term premiums and unconditional

tests of the pure expectation hypothesis are discussed. Results of the con-

ditional test of the pure expectations hypothesis and the determinants of

conditional term premiums are reported, and a conclusion is provided.

THE CHINESE INTERBANK REPO MARKET

The secondary markets for Chinese Treasury securities officially began

in 1990 when the securities exchanges were established. The trading

activities, however, have been limited. Unlike the case of the United

States, there are no regular cycles in Chinese Treasury issues. Although

the total number of Treasury bonds has now become nontrivial, most

bonds have long terms. There have been very few near-maturity bonds in

the last 5 years. As a result, there are no market-driven short-term rates

available from the Treasury market on a continual basis.The interbank market has always been the most important channel

for allocating resources across all sectors of the economy in China.

Imam (2004) has a brief account of the recent development in interbank

activities and its role in financial liberalization. Repo transactions are a

recent phenomenon in China. There are two major repo markets. One is

the market for exchange-traded repos and the other is the one for inter-

bank repos. Both mainly use Treasuries as general collateral. The trading

volume of the exchange-traded repo market was less than half of the

interbank repo market in 2003. The repo rates prevailing in the

exchange-traded repo market differ at times from those of the interbankmarket and are more affected by temporary factors in the stock market,

such as new issues. Therefore the focus here is on the interbank repo

market. Figure 1 shows the total amounts of interbank borrowing and

lending without collateral and with collateral (repo). As can be seen,

repo transactions have surpassed transactions without collateral since

1999 as the most important form of interbank borrowing and lending

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156 Fan and Zhang


FIGURE 1

Trading volumes of the interbank borrowing-and-lending market and of the interbankrepo market. This figure shows the annual trading volumes in the two markets from

1999 to 2003.

1The overnight repo is approved by the central bank for trading in 2003. The trading volume growsimmediately, accounting for 22% of the total volume in 2004. However, the data series of the

overnight rate is too short for analysis.

transactions, totaling more than 10 trillion RMB in 2002 and 2003. As

the problem of nonperforming loans lingers in the Chinas banking

industry, the rise of the interbank repo market is no surprise.

The interbank repo rate data used in this study are from the

www.chinamoney.com.cn Web site. The sample includes weekly observa-

tions of the one-week rate , the 2-week rate , the 3-week rate , the1-month (4-week) rate , the 2-month (9-week) rate , and the

3-month (13-week) rate , from July 2, 1999 to June 25, 2004.

Although the interbank repo market began in 1997, the trading volume

before 1999 was too small to warrant study. Table I gives annual trading

volumes for these categories by the term of the repo, as well as the

overnight repos, over the period of 19992003 and their proportions in

the entire interbank repo market. There are also other terms of repo

transactions that are not included in the table. They are of relatively low

importance according to their trading volume.1

Repo rates are quoted in the Chinese interbank market on the actual/365 basis. In the analysis conducted in this article the actual quoted rates

are converted to continuously compounded rates. Table II reports the

descriptive statistics of the repo rates of various terms. Panel A gives the

Yt13

Yt9Yt

4Yt3Yt2Yt1

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TABLE I

Trading Volume and Market Share of Repos by Term

Category 1999 2000 2001 2002 2003

A. Trading volume (billion RMB)

Overnight 1707.3

One-week 163.7 1054.0 3092.8 8227.0 7722.4

Two-week 93.4 239.0 470.4 1169.4 1320.4

Three-week 26.7 106.8 189.7 204.1 208.2

One-month 47.2 51.3 88.6 127.6 167.6

Two-month 31.5 65.3 49.7 75.2 86.1

Three-month 26.4 30.8 24.7 41.0 60.4

Entire market 394.9 1578.2 3924.3 9878.9 11306.0

B. Market share (%)

Overnight 15.1

One-week 41.5 66.8 78.8 83.3 68.3

Two-week 23.7 15.1 12.0 11.8 11.7Three-week 6.8 6.8 4.8 2.1 1.8

One-month 12.0 3.3 2.3 1.3 1.5

Two-month 8.0 4.1 1.3 0.8 0.8

Three-month 6.7 2.0 0.6 0.4 0.5

Sum 98.5 98.0 99.8 99.7 99.7

Note. Panel A of this table presents the trading volume of repos categorized by the term of the transactions.

Panel B gives their market share in percentage. The sample period is 19992003.

TABLE II

Descriptive Statistics of the Repo Rates

Term, n Mean SD 1 2 3 4

A. Rates (%)

One-week, Yt

1 2.3105 0.2654 0.8989 0.7643 0.6794 0.6136

Two-week, Yt

2 2.3385 0.2829 0.8789 0.7803 0.6664 0.5914

Three-week, Yt

3 2.3778 0.3016 0.8461 0.7438 0.6686 0.6170

One-month, Yt

4 2.4368 0.3139 0.8822 0.7825 0.7131 0.6771

Two-month, Yt

9 2.4764 0.3459 0.8858 0.7682 0.7133 0.7014

Three-month, Yt

13 2.5299 0.3459 0.8867 0.7958 0.7679 0.7294

B. Weekly changes in rates (%)

One-week, Yt1 Y

t11

0.0010 0.1169 0.1873 0.2614 0.1016 0.0762

Two-week, Yt

2 Y

t12

0.0007 0.1371 0.0979 0.0711 0.1732 0.0145

Three-week, Yt

3 Y

t13

0.0001 0.1651 0.1885 0.0737 0.0828 0.0651

One-month, Yt

4 Y

t14 0.0006 0.1464 0.0978 0.1096 0.1701 0.1024

Two-month, Yt

9 Y

t19 0.0015 0.1554 0.0118 0.2451 0.1099 0.0584

Three-month, Yt

13 Y

t113 0.0010 0.1533 0.0142 0.3035 0.0179 0.1349

Note. Panel A of this table presents the means, standard deviations, and autocorrelations up to order 4 of the

repo rates. Panel B presents the mean, standard deviation, and autocorrelations up to order 4 of the weekly

changes in repo rates. The sample consists of weekly observations in the period 1999.07.022004.06.25.

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158 Fan and Zhang


FIGURE 2

The 1-week repo rate and the 3-month term spread. This figure shows the weekly timeseries of the 1-week repo rate (the solid line), and the 3-month term spread

(the dashed line), from 1999.07.02 to 2004.06.25.S13t Y13t Y

1t

Y1t

means, standard deviations, and autocorrelations up to the fourth order of

the weekly repo rates. Panel B gives the means, standard deviations, and

autocorrelations up to the fourth order of the weekly changes of the repo

rates.

As we can see from Panel A of Table II, the term structure of therepo rates is upward sloped on average. The standard deviation also

increases with the term from 1 week to 3 months. The pattern in the

standard deviations is in contrast with that observed in the United

States. Longstaff (2000) reports that, although the overnight repo rate

has the highest volatility, there is no apparent pattern in the volatilities of

the repo rates ranging from 1 week to 3 months. From Panel A, the repo

rates all have high correlations which are slowly decaying.

The numbers in Panel B of Table II show that the average weekly

changes in the repo rates are very small, less than one basis point for all

the terms. The standard deviations are more than 10 basis points, much

larger compared with the means. The rate changes are weakly autocorre-

lated, compared to the rates themselves.

In order to gain more insight of the analysis for the repo rates that

follows, some of the repo rates are plotted in Figure 2. All the repo rates

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are close to each other. To avoid clustering, only the 1-week rate ,

and the 3-month spread, , are plotted. As seen in the figure,

the repo rates drifted slightly down from July 1999 to early 2002. In the

second half of 2003, there were two rate spikes. The difference between

the rates of different terms is typically small, as evidenced by the 3-month

term spread in the figure. In late 2003 and early 2004, the 1-week rate

went through some volatile fluctuations. The interesting observation is

that the 3-month rate did not fluctuate with the 1-week rate on a one-to-

one correspondence, resulting in some fluctuation in the term spread. In

many cases, the market correctly expected that the fluctuation in the

1-week rate was temporary, so the longer-term rates were set much more

smoothly over time than were the shorter-term rates.

UNCONDITIONAL TERM PREMIUMS

The analysis of term premiums is conducted in the backdrop of a dis-

cussion of the pure expectations hypothesis. There are many different

versions of the pure expectations hypothesis, as explained by Cox,

Ingersoll, and Ross (1981). Consequently, there are different definitions

of term premiums, that is, deviations from the pure expectations

hypothesis. However, as argued by Campbell (1986), the differences

among different versions of the pure expectations hypothesis are of the-

oretical importance only. The numerical magnitude of such differences

are negligible in practice. Fama (1984a, 1984b), Fama and Bliss (1987),

and Campbell and Shiller (1991) examine the various notions of term

premiums on U.S. Treasuries and reject the pure expectations hypoth-

esis. The interest in testing the expectations hypothesis, however, has

never abated. Balfoussia and Wickens (2004) identify macroeconomic

sources of the nonzero term premiums. Thornton (in press) clarifies the

Campbell-Shiller result from an econometric point of view. One line of

research extends the work to the international arena. For example,

Robinson (1998), Fernandez and Frutos (2000), and Hejazi, Lai, and

Yang (2000) analyze the Australian, Spanish, and Canadian markets,

respectively.

A study that is most relevant to this one is that of Longstaff (2000),

who analyzes the repo rates in the U.S. market and presents supporting

evidence for the pure expectations hypothesis for the short end of the

term structure of interest rates. This article follows one of the formula-

tions in Campbell and Shiller (1991).

For the continuously compoundedn-week repo rate at t, , one ver-

sion of the pure expectations hypothesis says that it equals the expected

Ytn

St13 Yt

13 Yt

1

Yt1

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160 Fan and Zhang


TABLE III

Unconditional Term Premiums in the Repo Rates

Term rates 1-week rate Term premium Newey-West Sample sizeTerm, n Y

t

n Rt

n Yt

n R

t

n t statistics T

A. Sample period for t: 1999.07.022004.04.02

Two-week 2.3368 2.3119 0.0249 3.6060 249

Three-week 2.3705 2.3106 0.0599 3.6907 249

One-month 2.4217 2.3098 0.1120 4.6609 249

Two-month 2.4627 2.3059 0.1568 4.3515 249

Three-month 2.5156 2.3033 0.2123 5.0175 249

B. Sample period for t: 1999.07.022002.08.30

Two-week 2.3352 2.3196 0.0156 4.2148 166

Three-week 2.3570 2.3179 0.0391 5.8306 166

One-month 2.3978 2.3166 0.0811 7.4061 166

Two-month 2.4285 2.3112 0.1173 5.5984 166

Three-month 2.4902 2.3069 0.1834 6.2590 166

C. Sample period for t: 2002.09.062004.04.02

Two-week 2.3399 2.2965 0.0433 3.2554 83

Three-week 2.3975 2.2960 0.1015 2.9553 83

One-month 2.4697 2.2961 0.1737 3.3341 83

Two-month 2.5311 2.2952 0.2359 2.9200 83

Three-month 2.5662 2.2960 0.2702 2.7086 83

Note. This table presents the average repo rates of various terms, , for n equal to 2 weeks,

3 weeks, 1 month, 2 months, and 3 months. In comparison is the average of corresponding average 1-week

repo rates, The term premium refers to their difference. The Newey-West t ratios are used to

test the hypothesis that term premium is zero. The sample size is the number of weeks T in the sample.

(1 T)aT

t1Rnt.

(1 T) aT

t1Ynt

n-week average of 1-week rates in the future, . That is,

(1)

Note that the 1-month,2-month, and 3-month rates are not exactly 4-week,

9-week, and 13-week rates, so the matching here is not perfect. But

because some have more days and others have fewer days, the difference

should not cause systematic bias, given that they are all annualized rates.

Panel A of Table III is for the entire sample period of 1999.07.02

2004.06.25. It reports the sample mean of , , and with the

autocorrelation and conditional heteroskedasticity consistent t statisticssuggested by Newey and West (1987). The lag in the autocorrelation

adjustment is chosen to be 30 weeks to account for the high autocorre-

lations in and the overlapping components in . The results show

that, on average, the longer repo rates are higher than the corresponding

rolling-over short rates; that is, tends to be positive. As indicated

by the t statistics, the difference in the averages as an estimate of the

term premium is significantly positive for all the terms considered in this

Ynt Rnt

RntYtn

Ynt RntR

ntYt

n

E[Ytn Rt

n] 0

Rtn

1ngj1n Ytj1

1

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article and the term premium increases with the length of the term. The

magnitude of the term premiums is small, however. The largest one is

about only 21 basis points on the annual basis that occurs for the

3-month ( ) term premium.

Figure 2 reveals that, over the entire sample period, there is a slightdownward trend in the level of repo rates. If the downward trend is totally

unexpected, then it is likely to observe a positive realized average value of

even when the pure expectations hypothesis holds. To see

whether or not this is the case, subperiod results are examined. Panels B

and C of Table III report the same statistics for two subperiods:

1999.07.022002.08.30 and 2002.09.062004.06.25. From Figure 2, it

can be seen that the first period is a period in which the level of the repo

rates declined overall, whereas in the second subperiod, the repo rates

fluctuated more without following a clear trend. If the positive realized

term premiums are entirely due to unexpected realizations, one should

anticipate higher realized term premiums in the first subperiod than for

those in the entire period and basically no realized term premiums in the

second subperiod. The numbers in Panels B and C, however, show the

opposite results. The realized term premiums are in fact slightly smaller

in the first subperiod than in the second one. This means that the posi-

tive realized term premiums found in the entire sample period are not

from unexpected changes in the level of repo rates, at least not entirely.

Figure 3 plots the difference for the 1-month rate ( )

and for the 3-month rate ( ). For both series, the difference

remains positive for almost all the time. The negative spike of

the difference in late 2003 is due to the large temporary fluctu-

ation of the level of the rates. Overall, although the repo rates in early

2004 fall back to the 2002 level, the realized term premiums are positive

on average.

CONDITIONAL TERM PREMIUMS

The pure expectations hypothesis can also be tested at the conditional

level. The hypothesis is stated as

(2)

where represents the expectation conditioned on time t information.

The hypothesis says that the value of should not be predicted by

any variable known at t. As a result, one can test the conditional version

of the pure expectations hypothesis by regressing on time tvari-

ables and testing whether the regression coefficients are all zero.

Ynt Rnt

Ynt Rnt

Et

Et[Ytn Rt

n] 0

Ynt Rnt

Ynt Rnt

n 13

n 4Ynt Rnt

Ynt Rnt

n 13

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162 Fan and Zhang


FIGURE 3

Longer-term repo rates in excess of rolling-over 1-week rates. This figure shows theweekly time series of the 1-month repo rate in excess of the rolling-over 1-week reporates, (dashed line), and the 3-month repo rate in excess of the rolling-over

1-week repo rates, (the solid line), from 1999.07.02 to 2004.04.02.Y13t R13t

Y4t R4t

The conditional version of the pure expectations hypothesis is

stronger than the unconditional version and, therefore, is easier to

reject. Given that the unconditional version of the hypothesis is rejected

in the last section for the Chinese interbank repo rates, it seems that

testing the conditional version of the hypothesis is beating a dead horse.

This view, however, is too scholastic. The purpose of testing a tightly

specified economic theory should not be the end of the academic inquiry,

but, rather, the beginning point of discussing broader issues surrounding

the extreme case represented by the theory. Tests of the conditional ver-

sion of the pure expectations hypothesis can provide important informa-tion about the determinants of conditional term premiums. Indeed,

many early tests of the pure expectations hypothesis are of the nature of

conditional tests.

In choosing conditioning variables, both the classical and modern

theories of the term structure of interest rates are examined. Among

several classical theories, the liquidity preference hypothesis stands

out as the main alternative theory that has more concrete predictions.

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2Casual observations show that the bidask spread of the repos is also increasing with the length ofthe term. However, the data on bidask spread for the sample period are not available.

The thrust of liquidity preference hypothesis is that a long-term bond is

less liquid than a short-term one and, therefore, investors who prefer

liquidity demand a term premium on the long-term bond with the term

premium increasing with the length of the term. A liquidity measure will

be constructed based on trading volumes of the repos to test whether itcontributes to the term premiums. There are many term structure models

that imply nonzero term premiums. In the most popular one-factor models,

such as those by Vasicek (1977) and Cox, Ingersoll, and Ross (1985), the

instantaneous rate serves as the only factor. Longstaff and Schwartz

(1992) add the conditional volatility of the instantaneous rate as a second

factor. More recently, Duffie and Kan (1996) use several key rates as

the factors of the entire term structure and as the determinants of term

premiums.

To construct the liquidity variable, the trading volumes of repo con-

tracts of different terms are used.2As Table I shows, the 1-week repo is

the most liquid, whereas repos of longer terms are less so. The trading

volumes of longer terms are not only smaller, but also more volatile

across terms and over time. The trading volume of the repo of any given

term is therefore not very informative. To create a meaningful variable,

the trading volumes are smoothed by taking averages across time and

across term. More specifically, let

(3)

where is the trading volume of thej-week repo in weekt. represents

how illiquid longer-term repos relative to the 1-week repo.

To construct the conditional volatility of the short-term rate, an

autoregressive model of order 3 is estimated with exponential general-

ized autoregressive and conditional heteroskedasticity of order (1,1), or

in short, AR(3)-EGARCH(1,1), as follows:

(4)

(5)

(6)

where is the conditional variance of . The order of the AR model is

chosen by the insignificance of the slopecoefficients of additional termsand

the order of the GARCH model for the conditional variance is chosen by its

popularity in the literature. Although these choices of the orders may affect

Yt1Ht

log Ht g u[et 2Ht1] a[|et| 2H

t1] b log Ht1

Vart1(et) Ht1

Yt1 f0 f1Yt1

1 f2Yt2

1 f3Yt3

1 et

LtVtj

Lt log a14a3

i0

Vti1 b log a1

5 aj2,3,4,9,13

14a

3

i0

Vtij b

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164 Fan and Zhang


TABLE IV

Descriptive Statistics of Conditioning Variables

0 1 2 3

A. Estimation of the AR(3)-EGARCH(1,1) model for

Parameter 0.159 0.855 0.200 0.275 0.420 0.033 0.617 0.984

t ratio (3.428) (19.510) (6.025) (4.303) (9.643) (1.738) (18.435) (54.787)

Lt Ht

B. Mean and standard deviation of conditioning variables

Mean 2.309 2.681 2.880 0.023 0.057 0.108 0.149 0.200

SD 0.267 0.760 8.746 0.058 0.092 0.116 0.164 0.177

C. Correlation matrix of conditioning variables

1.000 0.508 0.188 0.217 0.206 0.155 0.188 0.147

Lt

1.000 0.004 0.034 0.133 0.096 0.052 0.011

Ht 1.000 0.047 0.072 0.227 0.198 0.1791.000 0.637 0.306 0.261 0.213

1.000 0.455 0.470 0.417

1.000 0.757 0.746

1.000 0.851

1.000

Note. Panel A of the table presents parameter estimates of the model

,

where is the 1-week repo rate. Panel B presents the mean and standard deviation of the 1-week rate , liquidity Lt, the

conditional varianceH

t (multiplied by 100), and the yield spreads 3, 4, 9, 13. Panel C presents the correlationmatrix of , L

t, H

t, and , , 3, 4, 9, 13. The sample is weekly observations from 1999.07.02 to 2004.06.25.n 2SntY

1t

S

n

t, n

2,

Y1tY

1t

logHt g u[et 2Ht1] a[|et| 2Ht1] b log Ht1

Vart1(et) Ht1

Y1t f0 f1Y1

t1 f2Y1t2 f3Y

1t3 et

S13t

S9t

S4t

S3t

S2t

Y1t

S13tS9tS

4tS

3tS

2tY

1t

Y1t

3In an early version of the article a more complicated vector autoregressive (VAR) model is estimatedfor , where for , 3, 4, 9, 13, with the conditional variancefollowing an EGARCH model, similar to those of Bekaert, Hodrick, and Marshall (1997) andLongstaff (2000). The resultant Ht is very similar to the much simpler model discussed here.

n 2Snt Ynt Y

1t(Yt

1, S2t , S3t , S

4t , S

9t , S

13t )

the parameter estimation, the resultant Ht is not very sensitive to the order

of the model. The model is estimated with a quasi-maximum-likelihood

(QML) approach.3 It should be noted that, although Ht is the conditional

variance of the 1-week rate, it can be viewed as a multiplier of the condi-

tional variance of the repo rate of other terms as well because of the strong

correlations among repo rates of all the terms.

Panel A of Table IV presents the estimation results of (4)(6). The

first slope coefficient, , shows that the 1-week rate is quite persistent.The logarithm of the conditional variance is even more persistent with a

slope coefficient of its lagged value, , near one. In addition, the con-

ditional variance shows a slight asymmetry measured by the insignificant .u

b

f1

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The conditional variance tends to be greater when the unexpected shock

to the repo rate is negative.

Panels B and C report the mean, standard deviation, and the corre-

lation matrix of all the variables as candidates of the conditional term

premiums. The increasing pattern in the means and standard deviationsof is consistent with that observed in Table II. The correlations among

the variables are low except for that between Yt and Lt and those among

s.

The regression model of the following form is then estimated:

(7)

with various combinations of the conditioning variables. Some of the

results are reported in Table V. The regression coefficients are estimated

Ynt Rnt an bnY

1t cnLt dnHt enS

nt e

nt

Snt

Snt

TABLE V

Conditional Term Premiums in the Repo Rates

an bn cn dn en R2

n 2 0.2520 0.0990 0.0158 0.0021 0.1315

(2.7888) (3.0178) (2.5230) (5.7249)

0.0636 0.0250 0.0002 0.0022 1.0723 0.6265

(1.1682) (1.2458) (0.0482) (8.6403) (16.6620)

n 3 0.5571 0.2118 0.0437 0.0035 0.2217

(3.1976) (3.5330) (2.7725) (5.3191)

0.2340 0.0914 0.0069 0.0035 0.9501 0.6136

(2.0961) (2.2021) (0.9519) (11.2421) (13.5747)

n 4 0.5615 0.2363 0.0402 0.0067 0.3204

(3.1824) (3.9871) (2.1295) (6.6869)

0.4006 0.1620 0.0160 0.0048 0.7504 0.6125

(2.6876) (2.9410) (1.7365) (17.3479) (16.0226)

n 9 1.1878 0.5090 0.0543 0.0081 0.4702

(3.3499) (3.9005) (2.0210) (7.1384)

0.9925 0.4144 0.0305 0.0064 0.6165 0.6631

(3.5436) (3.7853) (1.7061) (13.3084) (9.1243)

n 13 1.2698 0.5771 0.0462 0.0080 0.4389

(4.0637) (5.0366) (1.7374) (4.7307)

1.1769 0.4944 0.0295 0.0058 0.7461 0.6981

(4.2120) (4.5183) (1.3013) (8.2322) (10.9914)

Note. This table presents the regression results for term premiums conditioned on either the term rate , or

the term spread , and the conditional volatility , of the 1-week repo rate,

where is the n-week repo rate, is the n-week rolling average of one-week rate, Ltis the liquidity measure

from trading volumes, Htis the conditional volatility, obtained from an AR(3)-EGARCH(1,1) model (and is multi-

plied by 100), and is the yield spread between the n-week rate and the 1-week rate. Numbers in the paren-

theses under the parameter estimates are Newey-West t ratios. R2s are the adjusted Rsquares. The sample is

weekly observations from 1999.07.02 to 2004.06.25.

Snt

RntY

nt

Ynt R

nt an bnY

1t cnLt dnHt enS

nt e

nt

H1tS

nt

Ynt

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166 Fan and Zhang


by OLS. The t ratios of the coefficient estimates are adjusted by the

Newey-West scheme with the use of a lag of 30 weeks.

The variables , and Ht are all useful in predicting the term pre-

miums. The signs of the slope coefficients are consistent with the theory,

and their estimates are mostly significant. The most useful variable, how-ever, is . The R2 with inclusion of jumps to more than 60%. In addi-

tion, substantially reduces the role of and totally subsumes the role

ofLt. Although the estimate of the slope coefficient of the conditional

volatility, Ht, is basically unchanged, its t ratio increases because of a

much smaller residual variance.

In summary, the results show that the conditional version of the

pure expectations hypothesis does not hold. The conditional term premi-

ums are related to the short-term rate, to term spreads, to the liquidity

measure, and to the conditional variance of the repo rates.

CONCLUSIONS

This article studies the behavior of the Chinese interbank repo rates with

terms from 1 week to 3 months. The repo rates have been used as the

benchmarks for market-determined short-term risk-free interest rates in

Chinese financial markets. Casual observations reveal that the market

has reached a certain level of sophistication. To some degree, the longer-

term repo rates reflect expectations of future fluctuation of the shorter-

term repo rates.One version of term premiums is analyzed as a deviation of the term

rates from the pure expectations hypothesis. The results show that the

term premiums are positive and increase with the length of the term.

The pure expectations hypothesis is statistically rejected, although the

magnitude of the term premiums is economically small. The conditional

term premiums are found to be related to the short-term repo rate, to

term spreads, to a liquidity measure constructed from trading volumes,

and to the volatility of the repo rates.

BIBLIOGRAPHY

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Bekaert, G., Hodrick, R., & Marshall, D. (1997). On biases in tests of the expec-tations hypothesis of the term structure of interest rates. Journal ofFinancial Economics, 44, 309348.

Campbell, J. (1986). A defense of traditional hypotheses about the term struc-ture of interest rates. Journal of Finance, 41, 183193.

Yt1Snt

S2tSnt

LtY1t ,

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