Financial Markets
After several years' slowdown in the financial markets, stock prices rose markedly during 2003 against the background of growing confidence in an economic upswing, particularly in the USA. Increasing optimism among the investors reduced the uncertainty concerning the future course of stock prices. By contrast, long-term yields were characterised by fluctuations.
The positive development in the financial markets in 2003 increased the banks' earnings from stock-related trading and asset management. The number of initial public offerings and mergers and acquisitions is low, thus the earnings from investment banking continue to be limited.
An analysis of the returns on stocks and bonds shows that the share of extreme returns has increased in recent years. This may be of significance to the risk management of financial institutions.
Market trends
Globally, stock prices rose considerably during 2003, reversing the negative trend since 2000. The stock markets in the USA, the euro area and Denmark increased by 39 per cent, 38 per cent and 33 per cent, respectively, from the beginning of April 2003 to the beginning of April 2004, cf. Chart 32. The strong increase in the Danish KFX index was driven by the A.P. Møller-Mærsk share, which has risen markedly following the merger between D/S 1912 and D/S Svendborg, among other things due to the large number of foreign investors buying shares in the merged company. In general, the shipping industry has benefited from growing trade and rising freight rates.
The overall increase in stock prices took place against the background of growing financial-market confidence in an economic upswing. The more optimistic economic outlook was mainly due to favourable data releases from the USA.
The increased optimism among market participants reduced the uncertainty concerning the future stock-price development, which was reflected in declining implied stock-price volatility, cf. Chart 32. Implied volatility is derived from option prices and indicates the cost to stock investors of hedging against fluctuating – especially falling – stock prices.
The development in long-term bond yields was characterised by strong fluctuations in 2003, especially in the USA, cf. Chart 33. During the 1st half of the year yields dropped to a very low level, but from June they rose considerably within a few months. Long-term yields decreased again during the first months of 2004, but increased in April following the release of favourable key indicators for the US economy. European government-bond yields fluctuated less strongly than US yields, but recent years have generally seen a high degree of co-variation between the different national financial markets.
The strong increase in yields over the summer was supported by a number of special factors, besides the increased optimism among investors concerning an economic upswing and thus expectations of higher short-term yields or higher inflation rates. One factor was the large government issues due to deteriorated government budgets. Risk-management mechanisms also played an important role. Financial institutions' hedging of the interest-rate sensitivity of portfolios of callable US mortgage-credit bonds thus boosted the rise in US yields. The rise in yields made investors sell from their portfolios of US government bonds, which are typically used for hedging[1]. This affected the European yield curve.
The implied volatility of long-term yields fell against the background of decreasing uncertainty among investors concerning the future interest-rate development, and fewer investors chose to hedge against falling interest rates, cf. Chart 33.
The very low yields on highly-rated government bonds made more investors invest in low-rated bonds in their pursuit of higher returns. The increased demand reduced credit spreads for low-rated government and corporate bonds (high-yield bonds) vis-à-vis highly-rated government bonds, cf. Chart 34.
Market impacts on banks
The general development in stock and bond markets has a direct impact on the banks' earnings via value adjustment of their portfolios of bonds and stocks and an indirect impact via their earnings in business areas such as asset management, investment banking and securities settlement. In addition, the general development in the financial markets affects the banks' costs of raising capital.
The positive trends in the financial markets during 2003 led to higher fee income from stock-related trade and asset management following the decline in 2002. Prices in the leading stock indices on the Nordic stock exchanges increased, as did the trading volume, cf. Chart 35. However, the number of new companies on the Nordic stock exchanges has not risen, and the merger and acquisition activity is low. Thus, the banks' earnings from investment banking are still limited.
| Trading volume on the nordic stock exchanges, index, 2001-04 |
Chart 35
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| Source: The Copenhagen Stock Exchange et al., The Nordic Securities Market, monthly statistics. | |
Stock prices for the largest Danish banking institutions in category B have risen considerably in recent years, cf. Chart 36. This may be due to the mergers and merger expectations, which typically cause stock prices to increase.
Financial stability and volatility in the financial markets
The risk management aimed at reducing the volatility of the financial institutions' individual results may sometimes amplify the overall volatility in the financial markets. Investors' hedging of the risk of callable mortgage-credit bonds may for instance create self-reinforcing interest-rate dynamics. Fluctuating stock and bond prices impact on the financial institutions' earnings and thus directly on financial stability. Chart 37 shows the volatility in the US stock and bond markets during the past nine years. Stock prices are typically much more volatile than bond prices. In recent years, the volatility of stock prices has been relatively high although it has decreased over the past year.
Both the implied and the historical volatility may describe the uncertainty that existed and exists in the financial markets. However, experience shows that financial stability is affected by extreme shifts in volatility rather than by the level of volatility. Financial crises are thus often characterised by very large shifts in volatility. Cases in point are the collapse of the stock markets in October 1987 (known as "Black Monday") and the credit crisis in 1998[2].
Table 5 shows the frequency of extreme shifts in stock and bond returns during the past nine years. The extreme returns have been divided into negative (-) and positive (+) returns. The frequency is calculated as the share of trading days with returns (numerically) higher than 2.6 times the standard deviation of the total sample. Under the assumption of normally distributed returns, the probability of such an event is less than 1 per cent.
As appears from the Table, there have been more extreme stock and bond returns than can be expected under the assumption of normally distributed returns. The share of extreme negative and positive returns is generally higher than 1 per cent. This may have an impact on the risk management of financial institutions. For instance, today many financial institutions use Value-at-Risk (VaR) models for risk management, in which extreme fluctuations are often assumed to occur very rarely. Table 5 shows that VaR calculations should not stand alone in risk assessments.
Extreme price fluctuations have become much more frequent in the stock market. The share of extreme stock returns is thus several times higher for the period 2000-04 than for the period 1995-99. This applies to both negative and positive returns. The bond markets have seen more negative than positive returns throughout the period.