Preferred-Habitat and Demand Factors in the Term Structure: Evidence from the Chinese Bond Market
37 Pages Posted: 12 Mar 2012 Last revised: 27 Mar 2013
Date Written: March 26, 2013
Recent empirical studies suggest that demand and supply factors have important effects on bond yields. Both market segmentation and preferred habitat hypothesis are used to explain these demand and supply effects. In this paper, we use an affine preferred-habitat term structure model and the unique Chinese bond market data to study these two hypotheses. Chinese bond market is unique because there exists an official term structure of lending rates, set exogenously by the government, on preferred habitat investors' alternative investments on loans. We show that demands of both the preferred-habitat investors and the arbitrageurs affect bond yields and returns. Moreover, we also find that the preferred-habitat investors' alternative investment opportunities have expected effect on bond yields and returns. We further show that the preferred-habitat and demand factors improve bond pricing and return predictability in a no-arbitrage term structure model. Variance decomposition analysis shows that the preferred-habitat factor explains an important part of bond yield variations.
Keywords: Preferred-habitat hypothesis, Market segmentation, Ocial interest rates, Bond demand, Affine term structure model
JEL Classification: E0, E4, G12, G10
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