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The share of foreign investors in the spot market for Korean government bonds has expanded significantly from just 1.6% in 2006 to nearly 20% in the second quarter of 2023. In particular, the share of foreign investors' trading in 3-year and 10-year government bond futures accounted for 44% and 53% as of 2022, making them major players in the government bond market. The influence of foreign investors in the government bond market is expected to expand further as the fiscal deficit is expected to continue for a significant period of time, and major domestic institutional investors such as national pension funds have announced plans to increase the proportion of overseas investments. Accordingly, analyzing the behavior of foreign investors in government bonds will become increasingly important for stable fiscal management and financial stability.

With this in mind, this paper examines whether the steep increase in the share of foreign investors in sovereign debt markets can be explained using empirical panel models for emerging economies. In addition, to understand the investment behavior of foreign investors in terms of financial stability, we analyze the impact of foreign trading on government bond yields and yield volatility by separating government bond spot and futures markets.

Using an econometric model that explains the share of foreign investment in local currency government bond markets in emerging economies, we find that the increase in the share of foreign investors in the spot market of Korea is consistent with the model, given the expansion of global liquidity and Korea's high sovereign credit rating. We also find that the trading behavior of foreigners in the spot market has not affected government bond yields or volatility so far.

On the other hand, in the futures market, where the share of foreigners is much larger than in the spot market, we find that foreigners' net purchases of government bond futures have a significant impact on the decline of government bond yields. In particular, the impact of foreigners' net purchases in the 10-year Treasury futures market is significant, and estimation by splitting the sample period confirms that the impact of foreigners in Treasury futures is even larger in the recent sample. On the other hand, despite the increase in foreign participation, we do not observe a significant wag-the-dog effect, where the price and volume of government bonds fluctuate rapidly on the expiration date, which may be due to the fact that the final settlement price in the government bond futures market, unlike the final settlement price of stock index futures and options, uses the average price calculation method on the expiration date.

Given the influence of foreigners in the government bond futures market, it is necessary to have a system that can detect and respond to abnormal trading behavior of foreign investors in the government bond futures market. It is necessary to expand the investor base by encouraging the participation of domestic institutional investors such as pension funds, insurance companies, and market makers in the government bond futures market to prepare for the possibility of clustering behavior by foreign investors in the event of an emergency. On the other hand, it is necessary to be cautious about increasing the share of retail investors in the government bond futures market, as a significant number of retail investors, unlike foreigners, have been analyzed to lose money in the market. With the listing of 30-year government bond futures on the horizon, it is necessary to strengthen retail investor education on the risks of investing in ultra-long-term government bond futures and consider improving the system to protect retail investors.