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The Japanese Repo Market: Theory and Evidence

  • This paper is an English translation of the Japanese original released in January 2002.

April 19, 2002
Naohiko Baba
Yasunari Inamura

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Repurchase Agreements (Repo) transactions are widely used as a risk-free means of raising or investing funds. Repo transactions can be categorized into the following two types: (i) general repos whose purpose is to borrow or lend funds, and (ii) special repos whose purpose is to borrow or lend securities. General repo transactions generate the linkage between the repo market and money markets including the interbank market, while special repo transactions generate the linkage between the repo market and securities markets, typically the government bond market. The objective of this paper is to examine the mechanism of the Japanese repo market from both theoretical and empirical perspectives.

First, this paper theoretically reviews a pricing mechanism of repo rates focusing on the linkage between the repo market and the government bond market. General repo rates are priced at a level close to the risk-free interest rate. However, special repo rates can be priced far below the general repo rates. Duffie (1996) and Krishnamurthy (2001) derived a mechanism by which repo rates are priced differently depending on the underlying issues. The mechanism is summarized as follows: (i) equilibrium in the repo market requires no-arbitrage profits from trading that combines repo and cash bond transactions (no-arbitrage condition), (ii) the equilibrium level of repo spreads, which are defined as the differences between general and special repo rates, is determined at the point where the supply and demand curves of the underlying bonds intersect in the repo market, and (iii) expected returns from future matched book trading are reflected in the cash prices of special bonds.

Second, the paper empirically examines the above theoretical implications using the data of repo rates and government bond prices in Japan. Our main findings are as follows: regarding the most recently issued (on-the-run) 10-year Japanese government bonds (JGBs) and the cheapest to deliver (CTD) issues, the no-arbitrage condition is significantly satisfied between the repo spread and the corresponding price premium in the cash market (cash premium), defined as the difference between the market price of special and general bonds.

Key Words:
Repo Market, Government Bond Market, No-Arbitrage Condition, Repo Spread, Cash Premium, Most Recently Issued (On-the-Run) Bond, Cheapest to Deliver (CTD),Short Sales