POLICY RISK: AN EMPIRICAL ANALYSIS OF THE CHINESE BOND REPURCHASE MARKETS

Abstract

This study investigates if policy risk is reflected in the interest rate risk, and if policy risk premium, if any, is priced in the Chinese Treasury bond repo markets. I investigate the presence of policy risk premium at both the short end and the longer end of the term structure.Policy risk is defined as the incremental interest rate volatility attributable to policy reversals.The sample used consists of daily repo rates on the Chinese Treasury bond markets for the period of 2000 through 2009, and hand-collected policy reversals and policy uncertainty events (termed collectively as policy risk events) for the period of 1994 through 2009. To avoid any endogeneity problems, I only sample those policy risk events that have no direct impact on the interest rate markets. There is evidence that policy risk is reflected in interest rate risk on the Chinese interbank repo market. I also find that investors are compensated for bearing policy risk arising from frequent policy reversals by the government. Policy risk is consistently priced at the longer end of the term structure, but not the short end. Findings also suggest that the policy risk premia are both statistically and economically significant. Recent policy risk events, in conjunction with a subsequent policy reversal, have carry-over effects on investors’ expectations for future short rates.