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This study analyzes two issues related to the GKO futures market in Russia in 1996 and 1997. First, we evaluate the existence of a risk premium in this market. We show its existence providing a functional form for the premium. The main result is that risk premium depends positively on the time before delivery of the futures contract. We provide anecdotal evidence in support of our results. Secondly, we study the degree of integration between GKO secondary and futures markets and its evolution over time. There is evidence of such integration, we found that this measure is time-varying and reveals the presence of a structural break in the market integration from April 1997 onwards.

The government short-term bonds (GKO) market in Russia was officially created in May 1993 and reached its peak in 1997 before its collapse in August 1998. Trading in GKOs had quite a complex structure, with informational linkages among all the various sectors: the primary auction, the secondary market, the futures market and the repo market.1 From the point of view of the Russian government, it was important to monitor not only the situation in the primary auction sector but also the behavior of the secondary market, given that the financial authorities used to place additional trances of the issued GKOs in the secondary market. Furthermore, GKO secondary market prices were often used to gauge inflationary expectations.2 The major role played by the GKO market on government finance makes it very important to investigate the whole structure of the market and the interaction of all its segments. Thus, the main aim of this research is to analyze different aspects of the interaction between the GKO futures market and the GKO secondary market. This suggests an econometric investigation of two phenomena: the presence of the risk premium in the GKO futures market and the degree of integration between the GKO secondary market and GKO futures market. Evidence of risk premium in futures bonds markets is widely documented in the literature on well-developed futures markets, such as those for Western European and US Treasury Bonds.3 Whether a risk premium existed in the market for Russian GKO futures was of interest to both domestic and foreign investors. For these agents, the possible presence of a risk premium in the futures market was a major determinant of the cost and benefits associated with hedging. Moreover, the risk premium was of importance to the Russian government as it could help to characterize the expectations of investors and, therefore, it may have been a useful indicator of the future spot rates for GKOs. As already mentioned earlier, the GKO market in Russia collapsed in the aftermath of the August 1998 crisis when it was defaulted and despite various attempts in 1999 and 2000 there is not yet a clear debt restructuring scheme. Why then is it still of interest to study this market now? Mainly because lessons can be learnt from what happened to the GKO market in the past for the Russian bond market in the future. Since the default of the GKO obligations in August 1998, the general principles of fiscal policy of the Russian Government have changed drastically. The rising of oil prices (with obvious benefits to the state budget which is largely dependent on oil revenue), better macroeconomic conditions and less uncertain political climate envisage deficit-free budgets, and by far lower reliance on domestic borrowing. However, the government has to honor the defaulted debt. Thus, Russia will have to resort to larger domestic financing. In fact the GKO/OFZ (see below) market is gradually recovering. Four new GKO placements were conducted in the year 2000 and the Budget Law for 2001 envisages additional placement of GKO/OFZ's worth US$2 billion (0.7% of GDP). Also, the market of GKO futures is expected to reopen over the next few months. Furthermore, in financial economics it is often assumed that various (segments of) markets are integrated, allowing analysis to proceed under ‘no arbitrage’ conditions. In reality, financial markets are not always perfectly integrated and this may have been the case for relatively newly established GKO markets in Russia. The possible imperfection may be interpreted also as a sign of inefficiency of the market. Thus, it is interesting to test the degree of integration between the GKO futures and secondary markets and to evaluate whether this measure changed over time.4 The remainder of the paper is organized as follows. Section 2 provides some background information on the Russian GKO market, including all its segments. Section 3 contains a description of the models used to test for the presence of risk premium and market integration, while the data and the empirical results are represented in Section 4. Section 5 concludes.

This study analyzes two issues related to the efficiency of the GKO futures market during its existence in Russia. The issue is of particular interest at the present when the GKO market is gradually recovering after it has been non-existent since the August 1998 crisis. Recent events suggest that Russia is resorting to larger domestic financing in order to honor the outstanding GKOOFZ debt amounting to the equivalent of some US$20 billion. Over the final few months of 2000 there have been clear signs that the GKOOFZ market is gradually recovering and the market for GKO futures is expected to re-open in the next few months. Lessons that may be learnt from the past then are of paramount importance and interest. Our paper is an attempt in this direction. Our main findings may be summarized as follows. Firstly, we tested for the presence of a risk premium in the GKO futures market  if we can estimate it and know futures quotations, we can then construct reasonable GKO yield forecasts. In our study we found evidence of a risk premium in the Russian market in 1996 and 1997. The size of the risk premium was positively related to the time before delivery of the futures contract, which is not surprising as there is more uncertainty about more distant events. The risk premium is almost always positive, meaning that over the period under consideration there was a permanent under-pricing, relative to the expected value, of the GKO in the futures market. This is in line with the fact that in the futures market there were mostly GKO holders who wanted to protect themselves against possible price decreases in the future and thus were willing to pay for such insurance in the futures market. We also found that the risk premium was greater in the MICEX than in the MCSE market. Once again we like to interpret this result as an indication that that big GKO holders efficiently solved the problem of the hedging of their GKO portfolios. Therefore, the established pre-crisis procedures of obligatory hedging of the non-residents positions at the GKO market on behalf and at the expenses of the CNRF seems unnecessary. It may be that those procedures attracted to the GKO market mainly speculative foreign investors, who ‘hit’ the market over this period but ‘run’ in the fall 1997
Spring 1998. There is a general consensus that the high pace of liberalization of the GKO market for foreign investors sharply increased the vulnerability of the GKO market from the foreign investors and the international financial market. This conclusion calls for some corrections of the pre-crisis regulation for the participation of the foreign investors in the GKO market, if indeed it will be re-established. The second main aim of this paper was to test whether GKO secondary and futures markets showed some degree of integration. We found that the value of the mean reversion parameter is negative and significant. This leads us to the conclusion that indeed there was a high degree of integration between GKO secondary and GKO futures markets. In addition, when we let vary with time, there is evidence that it becomes positive from the Spring of 1997 onwards, signaling that the degree of integration of these two markets had started to weaken, both as a consequence of the first wave of the Asian financial crisis and also the increasing demand of public borrowing. The market was clearly undertaking an inefficient pattern. To avoid a new financial crisis, the Russian Government not only has to carry out fiscal consolidation, but also improve significantly debt management practice. An overwhelming system of public debt management is being planned with the support of the World Bank. One of the key issues of such a system should be the prediction of interest rates for all categories of Government securities. The analysis presented above in this paper could contribute to forecasting GKOOFZ interest rates. In addition, it is quite evident from our results that foreign investors and the international financial market sharply increased the vulnerability of the GKO market. This calls for some corrections in the regulatory procedure in the future.