Price Discovery and Foreign Participation in Korea's Government Bond Futures and Cash Markets

• Published date: 01 January 2017
• Date: 01 January 2017
• DOI: http://doi.org/10.1002/fut.21785

Price Discovery and Foreign Participation

in Korea’s Government Bond Futures

and Cash Markets

Cyn-Young Park, Rogelio Mercado Jr.,* Jaehun Choi, and Hosung Lim

This paper examines the impact of foreign participation in Korean Treasury Bond (KTB)

futures and its role in price discovery, using daily transactions data from the over-the-counter

market and from the Korea Exchange for the futures. Our analysis suggests that foreign trading

in the KTB futures market leads the price discovery process for the underlying bonds. Empirical

results show that foreigners’daily net long positions in the futures market exert significant

influence in KTB and KTB futures prices. We also find that it is the unexpected component of

foreign investors’net long futures positions that explains a significant share of the pricing

effects. Our empirical results also suggest that information transmission between cash and

futures markets has improved significantly in the crisis and post-crisis period while local market

participants have become better in extracting information content from market transactions.

© 2016 Wiley Periodicals, Inc. Jrl Fut Mark 37:23–51, 2017

1. INTRODUCTION

The fast growth of local currency bond markets, combined with the wave of financial

globalization, boosted foreign participation in many emerging Asian markets. Local currency

bonds outstanding for nine emerging Asian markets reached $8.0 trillion in September 2014

from about $0.8 trillion in December 2000, up nearly tenfold. Data from AsianBondsOnline

show a clear upward trend in foreign participation across emerging Asian local currency

government bond markets since the mid-2000s.

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Growth accelerated even more following a

dip in late 2008 associated with the global financial crisis, as emerging Asia’s economic

Cyn-Young Park, Director, is at Asian Development Bank, Mandaluyong City, Metro Manila, Philippines.

Rogelio Mercado Jr., Graduate Student/Research Associate, is at Trinity College Dublin, Sutherland Centre,

College Green, Dublin 2, Ireland. Jaehun Choi, Senior Economist and Hosung Lim, Economist, are at the

Bank of Korea, Jung-gu, Seoul, Korea. We are deeply indebted to Choong Won Park, Sungjin Park, and Eun

Yeong Song for valuable research inputs and discussions during the course of the study. We are grateful for

the helpful comments and suggestions from Woon Gyu Choi, Jinho Huh, Jin-Su Park, Hyun-Jeong Kim, Jong

Ku Kang, Inseon Hwang, and also the seminar participants at the Bank of Korea in November 2014. We thank

the Editor, Robert Webb, and an anonymous referee for their insightful comments and suggestions. The views

expressed in this paper are those of the authors and do not necessarily reflect the views and policies of the

Bank of Korea (BOK) and the Asian Development Bank (ADB) or its Board of Governors or the governments

they represent. When reporting or citing this paper, the authors’names should always be stated explicitly.

JEL Classification: G10, G13, G14

*Correspondence author, Graduate Student/Research Associate, Department of Economics, Trinity College

Dublin, Sutherland Centre, College Green, Dublin 2, Ireland. Tel: þ353-873567526, e-mail: mercador@tcd.ie

Received September 2015; Accepted January 2016

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Data available at http://asianbondsonline.adb.org/regional/data/bondmarket.php?code=Foreign_Holdings

The Journal of Futures Markets, Vol. 37, No. 1, 23–51 (2017)

© 2016 Wiley Periodicals, Inc.

Published online 2 May 2016 in Wiley Online Library (wileyonlinelibrary.com).

DOI: 10.1002/fut.21785

resilience, in contrast to the financial turmoil in the United States (US) and the Euro Area

economies, made their local currency government bonds relatively more attractive to global

investors.

The Republic of Korea (Korea) has the second largest local currency bond market in

emerging Asia,

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with total bonds outstanding at $1.8 trillion. Starting with the

announcement of the Government Bond Market Stimulus Plan in August 1998, a number

of policy reforms have been undertaken, including the introduction of the primary dealer

system, interdealer market, and government bond futures in 1999. The Korea Exchange

introduced the cash-settled, three-year Korean Treasury Bond (KTB) futures contract on

September 29, 1999. The introduction of KTB futures effectively accelerated the growth of

the KTB market by facilitating price discovery of the underlying assets.

Foreign holdings of Korean government bonds are now nearly 15%, up from less than 1%

in the mid-2000s. Foreign interest in KTB futures has also been even stronger, accounting for

more than 40% of open interest. Foreigners find it easier to trade futures than cash bonds due

to taxation, leverage, and liquidity issues.

Foreign investors’active participation in the Korean bond markets has helped boost

market liquidity, depth, and sophistication. There are also concerns, however, about its

potentially destabilizing effects during financial turmoil. Market observers note that the local

bond markets seem to respond more sensitively to global financial conditions as foreign

participation grows. A few large foreign funds can herd on the same type of information. For

example, one or two large foreign traders can make substantially large transactions in one

direction, moving prices in the thin domestic futures market and subsequently affecting cash

prices. In mature markets with diverse investor groups, such herding would not be a problem,

as investors with heterogeneous information would form offsetting forces and make the

market more balanced. But in emerging markets with thin trading, a small number of large

traders on the same information or motivation may be able to dominate the market and

reduce the information content of the price at least for a short while. Domestic players also

closely monitor foreign traders, who are often viewed as better informed and more

sophisticated, and in turn, adjust their own trading.

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Better understanding of foreign investors’trading behaviors in futures markets and their

role in market efficiency and volatility is critical for assessing the risk of financial

liberalization and for designing a regulatory policy framework appropriate during rapid

financial market development.

The Korean case merits special attention in this regard. Following the Asian financial

crisis, Korean policymakers actively sought the development of domestic bond markets as an

alternative source of funding to foreign borrowing. A well-developed local currency bond

market can offer more diversified funding opportunities for the government and the private

sector in emerging market economies. In particular, the government bond market typically

provides a benchmark yield curve and helps establish the overall credit curve, laying the

market foundation for other issuers.

2

Emerging Asia in this paper refers to the nine economies in East and Southeast Asia covering the People’s Republic

of China; Hong Kong, China; Indonesia; the Republic of Korea; Malaysia; Philippines; Singapore; Thailand; and

Vietnam.

3

Agudelo (2007) investigated which types of investors (domestic or foreign) are likely to be better informed in

emerging markets. Although empirical evidence on the question of who is better informed (foreigners or locals)

remains mixed or inconclusive, he finds that, given the type of investors, foreigners are more likely to be informed

than locals. He argues that it may be because foreign flows tend to be driven by experienced and sophisticated

institutional investors. This is also consistent with Richards (2005) that foreign investors in emerging markets

represent “big fish”in small ponds and on average are more sophisticated than the locals.

24 Park et al.