Preferred-Habitat and Demand Factors in the Term Structure: Evidence from the Chinese Bond Market

37 Pages Posted: 2 Oct 2012 Last revised: 26 Mar 2013

See all articles by Longzhen Fan

Longzhen Fan

Department of Finance, School of Management, Fudan University

Canlin Li

Board of Governors of the Federal Reserve System

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School

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Date Written: January 10, 2013

Abstract

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 of loans. We show that demands of both the preferred-habitat investors and the arbitrageurs affect bond yields and returns. Moreover, we 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: the preferred-habitat hypothesis, market segmentation, official interest rates, bond demand, affine term structure model

JEL Classification: E0, E4, G12, G10

Suggested Citation

Fan, Longzhen and Li, Canlin and Zhou, Guofu, Preferred-Habitat and Demand Factors in the Term Structure: Evidence from the Chinese Bond Market (January 10, 2013). Midwest Finance Association 2013 Annual Meeting Paper, Available at SSRN: https://ssrn.com/abstract=2146860 or http://dx.doi.org/10.2139/ssrn.2146860

Longzhen Fan

Department of Finance, School of Management, Fudan University ( email )

Shanghai, 200433
China
86-21-2501-1093 (Phone)
86-21-6564-8384 (Fax)

HOME PAGE: http://www.fdsm.fudan.edu.cn/en/teacher/preview.aspx?uid=1794

Canlin Li

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-2227 (Phone)

Guofu Zhou (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

Washington University
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6384 (Phone)
314-658-6359 (Fax)

HOME PAGE: http://apps.olin.wustl.edu/faculty/zhou/

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