Financial Markets

Equity prices have been on the rise in Denmark and abroad since the spring of 2003. The market assessment of the uncertainty of future equity prices (implied volatility) has returned to a relatively stable level following the market uncertainty during the period from 2001 to mid-2003. The equity prices of major Nordic financial groups (category A) have matched the rises recorded by European banks in 2004.

The European interest-rate market, as opposed to the stock market, has been characterised by great uncertainty as to future interest-rate developments. As a result, implied volatility has been rising since the summer of 2004.

European credit spreads continued to narrow in 2004, though the tendency was not as pronounced as in 2003.

Banking institutions' earnings and balance sheets are affected by financial market developments. There is a direct impact through various channels – partly in the form of value adjustments of the banking institutions' bond and stock portfolios and partly through fee and commission income from financial market-related customer services, such as asset management, trading and advisory services in connection with public offerings. Financial markets also have an impact on the financial situation of the banking institutions' clients and financial counterparties.

In addition, the general development in the financial markets affects the banks' costs of raising capital through bond or equity issues.

In general, equity prices have been on the rise in Denmark and abroad since early 2003, cf. Chart 30. This trend was, however, briefly reversed in the summer of 2004 in response, among other things, to disappointing economic indicators, especially in the USA. The high degree of co-variation between various equity indices in 2003 and the 1st half of 2004 was reduced in the 2nd half of 2004 when Norwegian equities, in particular, stood out with large price increases.

The market assessment of the uncertainty relating to future equity prices can be expressed by implied volatility, calculated on the basis of the price of equity options.

The implied volatility of the US S&P 500 index seems to have returned to a stable level after showing a slightly declining trend throughout 2004, cf. Chart 30. This indicates that the generally high uncertainty in 2001 and late 2002, as well as in early 2003, prompted by the terrorist attacks in the USA and the war in Iraq, no longer has any significant impact on the stock market.

The equity prices of the Nordic groups outperformed the equity prices of banks in the euro area in the 2nd half of 2004. This is probably attributable to the more favourable economic conditions in the Nordic countries than in the euro area in general.

Yields on 10-year government bonds in Europe and the USA have declined by approximately 0.9 and 0.5 percentage points, respectively, since the summer of 2004, cf. Chart 32. Having moved in tandem in the 1st half of 2004, European and US yields were decoupled in the 2nd half of 2004, since US yields started rising, while European yields continued to fall. The greater decline in European yields relative to US yields may be ascribed to uncertainty as to the strength of the economic upswing in Europe, as well as to prospects of continued monetary-policy tightenings in the USA.

In the wake of the decoupling of European and US yields, uncertainty as to future interest-rate developments in Europe, measured in terms of implied volatility, increased sharply and was at a relatively high level at the beginning of 2005. In addition to the element of uncertainty, part of the rise in implied volatility may be explained by a strong demand for hedging the risk of higher interest rates, cf. Box 9. The implied volatility in Chart 32 has been calculated for options with a maturity of 10 years.

In the short term, equity prices and interest-rate developments match the development in implied volatility fairly closely. Higher implied volatility in stock markets typically translates into declining equity prices, while higher implied volatility in the bond market typically results in lower interest rates, cf. Charts 33 and 34. The Charts illustrate the development in equity prices and bond yields relative to their respective trends, compared with the corresponding development in implied volatility.

CREDIT SPREADS IN EUROPE

In general, credit spreads, i.e. the spread between corporate and mortgage-credit bond yields and the yield on a safe government bond, have narrowed significantly since 2003 and currently stand at a low level, cf. Chart 35. The narrowing may be attributed, among other factors, to the low interest rates and the correspondingly lower earnings potential of high-rated government bonds. This has attracted investors to less safe investments in order to achieve a higher expected return. Moreover, the general supply of corporate bonds has decreased.

CREDIT SPREADS FOR EURO-AREA BONDS, 1999-2005	Chart 35
Note: Aggregate index of liquid euro-denominated bonds. The credit spread indicates the spread between corporate and mortgage-credit bond yields and safe government bond yields.
Source: J.P. Morgan and EcoWin.

Credit spreads – especially for low-rated bonds – are also sensitive to general economic cycles. The widening of the spread until 2003 took place in a period with declining growth in the USA and the euro area.

INTEREST-RATE EXPECTATIONS DERIVED FROM MARKET PRICES

Prices of financial assets contain information on market participants' expectations as regards future market developments. For instance, based on yields on bonds with different maturities, it is, possible to calculate forward rates, reflecting expected future interest rates, among other things. The forward rate between, for instance, year 5 and year 10 reflects what the 5-year yield should be in five years in order for an investor to achieve the same return when choosing either a 10-year bond – the return on which is currently known – or a 5-year bond – the return on which is currently known – followed by yet another 5-year bond with the yield in question. In other words, the forward rate is a break-even rate. Other factors besides market expectations also affect prices, namely risk premiums and specific supply and demand factors.

The full probability distribution of the future rate may be estimated on the basis of interest-rate option prices, cf. Box 8. Chart 36 provides an example of one such calculation based on option prices and interest-rate futures 1, 2, 3 and 5 months ahead on the yield of the German benchmark 10-year government bond. At the time of calculation, the forward rate was showing a slightly rising trend for the period until September. Gradually wider confidence bands indicate that the expectation becomes more uncertain, the longer into the future the forward-rate projection goes. Moreover, the distribution is not symmetrical around the forward rate, but skewed to the right. In other words, market participants find it more likely that interest rates will be relatively higher than the forward rate, than that interest rates will be lower than the forward rate. The width of the confidence bands may also be used to assess the size of the interest-rate scenarios used to analyse the interest-rate risk of banks and households, cf. the chapters on the financial sector and the interest-rate exposure of Danish homeowners.

INTEREST-RATE OPTIONS

Box 8

An interest-rate option is a right, but not an obligation, to borrow or lend capital at a predetermined price (interest rate), the strike price. Interest-rate options may have different strike prices and investors may, for instance, hedge against the risk of an interest-rate increase or an interest-rate drop exceeding a certain level by buying or selling interest-rate options at specific strike prices. Thus the price of the actual interest-rate option reflects the market participants' assessment of the probability that the future market rate is above or below the interest rate calculated on the basis of the option strike price. Option prices are also affected by risk premiums, as well as specific supply and demand factors analogous to the description of forward rates. In other words, the prices of interest-rate options with different strike prices depend not only on the forward rate, but on the full probability distribution of future interest rates. The implied volatility of the probability distribution may be calculated on the basis of the price of a single option. This calculation does, however, presuppose firm assumptions about the probability distribution underlying the pricing of the option. The full implied probability distribution of future interest-rate trends may be assessed on the basis of the prices of interest-rate options with different strike prices. Thus, there is no need to make explicit advance assumptions about the distribution function of interest-rate developments that underlies option prices.

INTEREST-RATE EXPECTATION DERIVED FROM OPTION PRICES, 2005	Chart 36
Note: Risk-neutral probability distributions calculated on the basis of prices on 14 April 2005 for options on the German Bund interest-rate futures expiring in May, June, July and September 2005. The method is based on Andersen, Allan Bødskov and Tom Wagener, Extracting risk neutral probability densities by fitting implied volatility smiles: Some methodological points and an application to the 3M Euribor futures option prices, Danmarks Nationalbank, working paper no. 9, 2002.
Source: Bloomberg and own calculations.