Flight-to-Liquidity and Flight-to-Quality: A Lesson From the Japanese Financial Crisis

Abstract

This paper empirically examines liquidity asset pricing based on Japanese investor's liquidity demand and liquidity preference. We have analyzed Japanese public bond spreads with control of credit risk and macroeconomic conditions during Japanese financial crisis period, 1997-2002. Japanese public bond spreads have considerably expanded during Japanese financial crisis and credit crunch. As Japanese investors are scared of shortage of fund liquidity, they tend to move their assets in advance to high quality bonds (high rating bonds) and high liquidity sovereign bonds such as Japanese Government Bonds (JGB). So that Japanese investors can hedge chain-reaction bankruptcy and liquidity crisis which is called the and the flight-to-quality. We define flight-to-quality as investors fly their money to liquidity high rating bonds during financial crisis, and define flight to liquidity as investors fly their money to more liquidity assets, sovereign bonds (JGB) during financial crisis. Holmstrom and Tirole(2001) have shown theoretical framework of Liquidity Asset Pricing Model(LAPM). Investor's behavior of buying and holding sovereign bonds and high rating bonds takes place at expectation of immediate future financial demands. Our empirical analysis is based on LAPM theoretical work. According to results of our empirical analysis, we find that when Japanese investors are scared of financial crisis in future, they tend to hold high rating bonds and high liquidity JGB, and flight-to-quality and flight-to-liquidity affect Japanese bond spreads. The flight-to-quality is occurred by Japanese investor's liquidity preference and flight-to-liquidity is occurred by Japanese investor's liquidity demand. And we find power of flight-to-liquidity is stronger than flight-to-quality in Japan. Our empirical study is different from previous empirical studies. Those studies focused on market-microstructure which analyzed daily trading system and asset pricing of bid- ask spread. Our study analyze liquidity asset pricing (bond spreads) focusing on investor's liquidity demand and liquidity preference during periods of economic downturn and financial crisis.