The Effects of Open Market Operations on the Price Discovery Process in the Japanese Government Securities Market: An Empirical Study Hirotaka Inoue* Financial Markets Department Bank of Japan Email: [email protected] Abstract The objective of the paper is to deepen our understanding of the price discovery process of the government securities market by exploring the effect of notification of open market operations (OMOs) by central banks. The adopted methodology empirically examines the immediate effects of notification of OMOs by the Bank of Japan (BOJ) on trading volume and price volatility for the 10-year benchmark issue in the Japanese government securities market, using tick-by-tick trading data in the interdealer brokers market. The main findings of this paper are as follows: 1) Outright OMOs (outright purchases or coupon passes) increase the spikes in trading volume and price volatility, but temporary OMOs (purchases with sell-back agreements and repos) or outright purchases by the Ministry of Finance do not affect the spikes, and 2) unexpected changes in purchase amounts and notification times of OMOs increase the spikes. Key words: Open market operation, price discovery process, government securities market JEL classification: E52, G14 * The views expressed in this paper are solely those of the author and do not necessarily represent views of the Bank of Japan. 1. Introduction The arrival of public information is one of the key factors of the price discovery process in the securities markets. In the case of government securities, the role of public information is more pronounced when compared to the case of equities, where trading is likely to be primarily induced by private information. Among the various sources of public information, the notification of open market operations (OMOs) by central banks seems to be an important driver of trading activities. This is because notification may contain new public information on monetary policy. It is also a placement of a large buy/sell order, which could affect the supply-demand conditions of securities in the private sector. These characteristics are what market participants cannot find in private transactions. In this paper, the immediate effect of the notification of OMOs is examined focusing on the intraday price discovery process in the government securities market. The paper’s methodology is to empirically examine the relationship between various aspects of notification of OMOs by the Bank of Japan (BOJ) and the smoothness of the price discovery process by observing the spikes in trading volume and price volatility. The examination is based on tick-by-tick trading data of the benchmark issue in the interdealer brokers market for the five minutes immediately after the notification of OMOs. The underlying assumption of this examination is that smaller observed spikes indicate a smoother price discovery process. The process may be smoother when market participants sense that the BOJ simply wishes to provide liquidity to the market. Large spikes in trading volume and price volatility, which might lead to changes in equilibrium price, may arise if market participants interpret the OMOs as an indication that the BOJ wishes to show its monetary policy intentions. To the best of my knowledge, this is the first paper to deal with the impact of notification of OMOs in the Japanese government securities (JGSs) market based on intraday tick-by-tick data. This paper attempts to, first, draw policy implications on how OMOs should be conducted in a way to, (or not to,) affect the smoothness of the price discovery process, and second, to empirically draw general implications on the effects of public information on the price discovery process in the government securities market. An outline of my findings is as follows. 1) Outright OMOs (outright purchases or coupon passes) increase spikes in trading volume and price volatility, but temporary OMOs (purchases with sell-back agreements and repos) or outright purchases by the Ministry of Finance do not affect trading volume and price volatility, and 2) unexpected changes in purchase amounts and notification times of OMOs increase the spikes. The paper is organised as follows. Section 2 describes the market structure of and the price discovery process in the cash interdealer market for JGSs. Section 3 characterises the data used in the analyses and explain the calculation process for trading volume and price volatility. Section 4 illustrates the features of OMOs in Japan. Section 5 tests a variety of hypotheses on different features of the OMOs. Section 6 draws some conclusions and identifies areas for possible future study. 2. The interdealer market for JGSs 2.1 The market The interdealer market for JGSs serves two primary purposes. First, it is used for hedging purposes by dealers trying to adjust their positions in cash JGSs created by customer transactions. Second, it offers dealers a market for speculative transactions. The daily trading volume of total interdealer transactions was about 17 billion dollars in 1997 on a two-way basis, according to a BOJ estimate. Interdealer trading takes the form of either direct transactions between dealers or transactions intermediated by brokers. For the latter, pre-trade and post-trade anonymity are ensured, i.e. the counterparty’s name is not revealed even after the trade. Therefore, dealers generally prefer interdealer 1 broker trading. Although official statistics on the breakdown between the two are unavailable, about 70% of all interdealer transactions of JGSs are estimated to be broker intermediated. There are currently seven interdealer brokers – five domestic and two foreign-owned – operating in the JGS market. In terms of trading volume, the Japan Bond Trading Co. (JBT) handles an estimated 70% share of the market. This paper focuses on JBT trading data.1 2.2 The price discovery process The JBT provides an order-driven market where buy-orders and sell-orders are continuously matched in the order-book according to the “best-price” and “first-in” rule. The JBT is open from 8.40 to 17.00 with a lunch break from 11.05 to 12.25. During operating hours, orders are placed according to yield terms (simple yield), with a tick size (the smallest increment of yield changes) of 0.5bp. Only limit-orders can be placed, meaning that one must specify the amount and yield when placing an order. Let us first look at the order matching procedure. Suppose dealer A places a two billion yen sell-order for the 182nd issue of 10-year JGS at 1.200% by making a phone call to the JBT. The placed order is shown on the screen of the computer terminal located both at the JBT and at the client dealers of the JBT.2 When another client dealer, dealer B, finds the order on the screen that fits its needs, dealer B hits the order by making a phone call to the JBT.3 In this way, the orders are matched. The matched orders are eliminated from the computer screen. The JBT charges a commission of 0.1/10,000 (remaining maturity of 2 years or less) or 0.18/10,000 (remaining maturity of more than 2 years) of the face value for each side of the trade. 3. Data and basic intraday patterns 3.1 Data The data cover two years of tick-by-tick contracted yields and trading size of transactions through the JBT. The sample period is from July 1 1996 to June 30 1998 (493 business days), when the market was generally bullish (Figure 1). The paper focuses its analysis on the 10-year benchmark issue (182nd issue), which remained the benchmark throughout this period.4 In the sample period, trading seems to be on a declining trend, which indicates a decline in the “benchmarkness” of the 182nd issue. This phenomenon may be explained in the following way. First, assuming that investors/dealers generally prefer securities which have a remaining life close to the “key maturities”, a benchmark with a remaining maturity much shorter than 10 years may not be preferred.5 Second, as time passes, more securities are included in portfolios of investors who employ buy-and-hold strategies. This means less securities are in the hands of active traders, which eventually leads to a decline in the market’s trading activity. 1 Only the JBT publicly discloses trading data. 2 The yield and the size of the order are posted on the screen. However, the name of the dealer placing the order is not shown. 3 Placing and hitting orders are only possible via telephone. 4 Contrary to practices in most markets, there exists only one benchmark for the JGS market. Although no official rule exists, the benchmark is usually a 10-year off-the-run issue which has a large issue amount with a remaining maturity of 7 years or longer. 5 Since the 182nd issue will be redeemed in September 2005, its remaining maturity in the sample period was 9.2 – 7.2 years. 2 3.2 Measuring trading volume and price volatility The paper analyses trading volume and price volatility for 5-minute segments. Using JBT’s operating hours (8.40 to 17.00, with a lunch break from 11.05 to 12.25), there are 84 segments per day. Trading volume is measured according to the total face value of securities traded during each 5-minute segment, which is recorded in 500 million yen increments. The calculation is done on a one-way basis, i.e. when dealer A sells one billion yen in securities to dealer B through the JBT, the transaction is recorded as one billion yen, not two billion yen. Price volatility is measured by the standard deviation of the yield in terms of 0.1 basis points gauged every minute (not every 5 minutes) for the 5-minute segment.6 For example, suppose that on a certain day the yield of the 182nd issue developed as follows: Time Yield 10:10 1.500% 10:11 1.505% 10:12 1.505% 10:13 1.510% 10:14 1.505% 10:15 1.500% In this case, the price volatility for the 10.10 segment (from 10.10 to 10.15) is calculated as the standard deviation of 1,500, 1,505, 1,505, 1,510, 1,505, and 1,500, which is 3.76.