Financial Markets

Equity prices have been rising since the beginning of 2005, and the market assessment of the uncertainty of future equity prices (the implied volatility) has been stable at a low level. For the Nordic financial groups, category A, equity prices have mirrored the rising prices of European banks.

Unlike the equity market, the European interest-rate market has been characterised by considerable uncertainty as to future interest-rate developments. However, this uncertainty has subsided, and in the short term the market participants expect European interest rates to rise. This has presumably contributed to the widening of the credit spreads for corporate bonds. The interest-rate outlook indicates a considerable risk of further adjustments in the markets for high-risk assets.

THE SIGNIFICANCE OF FINANCIAL MARKETS TO FINANCIAL STABILITY

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 equity portfolios, and partly via fee and commission income from financial-market-related customer services, such as asset management, investment credits, trading, and advisory services in connection with public offerings. The 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 via bond or equity issues.

THE EQUITY MARKETS

Equity prices have been rising since early 2005, cf. Chart 34, partly as a result of improved growth prospects. The development has been more subdued in the USA than in the euro area because the strong economic development in the USA had to some extent been incorporated into US equity prices at the start of 2005. In addition, monetary policy has been tightened more in the USA than in Europe, and the dollar has strengthened vis-à-vis the euro.

The higher equity prices have generally improved the results of financial companies and also indicate that the market has more confidence in the corporate sector and thus in the banks' customers.

The market assessment of the uncertainty concerning future equity prices can be expressed as the implied volatility^[1], which can be calculated on the basis of equity option prices, cf. Box 10. Compared with the level in recent years, the implied volatility of the German stock index (DAX) been stable at a low level has since the beginning of 2005, cf. Chart 34. This increases the risk of a pronounced upward movement. Higher uncertainty makes equities a more risky investment, and in such a scenario equities therefore tend to fall.

OPTIONS AND IMPLIED VOLATILITY	Box 10
An equity option gives the buyer the right, but not the obligation, to purchase an equity at an agreed price (the strike price) at a future point in time. 1 An interest-rate option gives the buyer the right, but not the obligation, to borrow capital at an agreed rate of interest at a future point in time. The buyer only achieves a gain if the price/interest rate at the expiry of the option is higher than the strike price. The gain is the difference between the strike price and the market price. The expected value of the gain (and thus the price of the option) is the average gain, provided that the price is higher than the strike price.
TODAY'S PRICE FOR AN OPTION DEPENDS ON THE EXPECTED VOLATILITYOF THE EQUITY/INTEREST RATE
The Chart illustrates two situations where in each case the price is expected to remain unchanged. However, the expected volatility (uncertainty) is greater in the blue scenario – large increases and large falls are deemed to be more probable, while an unchanged price is deemed to be less probable than in the yellow scenario. Consequently, the expected gain from owning the option is greater in the blue scenario (the green and brown areas) than in the yellow scenario (the brown area only). The greater the uncertainty, the more valuable it becomes to hedge. The implied volatility on which the price is based can be calculated using the strike price and the market price of the option.
1 These examples are based on call options. Put options, on the other hand, give the buyer the right, but not the obligation, to sell at an agreed price.

The development in equity prices for the Nordic financial groups (category A) is illustrated in Chart 35. The significant increases in equity prices for the Nordic groups in the 2nd half of 2004 continued in 2005 and early 2006. The market participants thus assess the value of the banks to be higher, and this reduces the banks' financing costs. The correlation between the price development for Nordic financial groups' equities and bank equities in the euro area points to integration of the financial markets in Europe, and consequently bank equities could to some extent be subject to fluctuations that are not driven by expectations of growth in their own earnings.

GOVERNMENT-BOND MARKETS

Since mid-2005, yields on government bonds have risen in the USA and Europe, cf. Chart 36. Danish yields have matched those of the euro area. In both regions short-term yields have risen particularly. The development reflects monetary-policy tightening in response to increased economic activity.

Fundamentally, the subdued development in long-term yields should be taken as an indication that in the long term inflation is expected to remain stable at a low level. In addition, institutionally determined demand for long-term bonds from pension companies and Asian central banks may have contributed to keeping long-term yields down. The commitments of pension companies resemble long-term bonds in that they are of long duration. A number of countries are introducing accounting rules that are similar to the Danish rules, i.e. commitments must be book-entered at market value, and the pension companies therefore invest in long-term bonds in order to reduce the risk of insolvency. The Asian central banks' demand for US bonds is especially attributable to current-account surpluses in Asian countries and a wish to maintain stable exchange rates vis-à-vis the dollar.^[2]

The market's assessment of the uncertainty regarding future interest rates can be measured as the implied (interest-rate) volatility, which can be determined via the prices of interest-rate options^[3], cf. Box 10. In 2005 the implied volatility of 10-year interest rates in Europe rose substantially due to increased uncertainty concerning the future level of interest rates^[4], cf. Chart 36. The reason may be that the economic situation led to uncertainty as to the future official interest rates in Europe. In step with the improved prospects for the European economy and rising inflation, the ECB has raised its official interest rate and reduced uncertainty in the market, cf. below.

Another explanation could be that there is typically a negative correlation between the level of interest rates and implied volatility, cf. Chart 37. This correlation reflects, among other things, that e.g. pension companies operate with interest-rate guarantees and therefore purchase interest-rate options that ensure a certain minimum return on assets. The demand for such options increases when interest rates fall, which entails higher implied volatility. In other words, the development in the implied volatility is attributable to other factors than uncertainty concerning interest rates.

CREDIT SPREADS IN EUROPE AND THE USA

After having narrowed for several years, credit spreads^[5] in Europe have widened slightly since the beginning of 2005, cf. Chart 38. This may reflect the rising level of interest rates. In recent years, investors have used the low interest-rate levels to finance purchases of high-risk assets, including credit bonds, which has exerted upward pressure on prices (and narrowed the yield spread). This tendency may be reversing now.

Credit spreads have widened more in the USA, and consequently the difference between the credit spreads for e.g. A-rated bonds in the USA and Europe has increased. However, the US and European credit spreads have generally been closely correlated so that wide spreads in the USA coincide with wide spreads in Europe. One of the consequences of the close correlation is that European corporate bonds are exposed to changes in the US credit spread. This partly explains why the downgrading of General Motors and Ford in May 2005 led to a widening of the European low-rated credit spreads, cf. Chart 38.^[6]

The substantial widening of the credit spread in May 2005 shows how volatile credit spreads in low risk classes are. This volatility does not necessarily reflect an increased risk of insolvency, but rather that the price of risk (risk premium) is volatile. The credit spreads fluctuate too much over time to merely reflect the probability of insolvency. The implication is that it is difficult to derive the credit risk from the credit spreads.^[7] Furthermore, the fluctuations in the indices are for a given rating, and since a bond's rating changes if the credit standing changes, the fluctuations will underestimate the investment risk.

The wider credit spreads have entailed capital losses for investors and have increased financing costs for the corporate sector, including the banks. So far the impact has, however, been small.

INTEREST-RATE EXPECTATIONS DERIVED FROM OPTION PRICES

The prices of financial assets contain information on the market participants' expectations of future market developments. Forward interest rates can be calculated on the basis of yields on bonds with different maturities and can be seen as break-even interest rates. The forward interest rate between e.g. year 1 and year 2 shows the 1-year interest rate one year ahead if an investor is to achieve the same yield by purchasing either a 2-year bond – of which the yield is known today – or a 1-year bond – of which the yield is known today – followed by another 1-year bond at the forward interest rate.

The full break-even probability distribution for the future interest rate can be derived on the basis of the prices of interest-rate options. In this distribution, the forward interest rate is the mean value. Chart 39 shows this calculation for the 3-month Euribor (Euro InterBank Offered Rate) using prices for traded options written on the Euribor future.

It is seen from the forward interest rate that the market participants expect short-term interest rates to rise. The observations can thus be interpreted to indicate that the (option) market expects further monetary-policy tightening in Europe. A 3-month interest rate of approximately 3.75 per cent is expected in March 2007. The distribution shows that the uncertainty about the level of interest rates increases as we move further into the future. The market thus operates with a very small probability that the interest rate only increases to 3 per cent in March 2007.

The interest-rate expectations in the spring of 2006 can be compared to the expectations at various times in 2005, cf. Chart 40. It is seen that the expectation of the interest rate eight months ahead has risen, particularly from October 2005 to April 2006.

There has also been a shift in uncertainty, which was comparatively low in April 2005, when unchanged or marginally increasing interest rates were seen as relatively likely. In October 2005, market participants were more uncertain about the imminent development, which is seen from the broader distribution with a lower peak. Since then uncertainty has diminished again, possibly because the ECB has begun to tighten its monetary policy.

If interest rates increase, capital losses on bonds will continue, and at the same time credit spreads may widen, which will amplify the increase in corporate financing costs. Many households with adjustable-rate loans will also see an increase in their payments. If the development also affects long-term interest rates, however, the pension companies' commitments will decrease. The debt of households with fixed-rate loans will also decrease.

Many analysts link the rising prices for high-risk assets in recent years to the lower level of official interest rates since investors have utilised the opportunity to raise inexpensive loans for investment in e.g. corporate bonds, commodities and property. This trend may therefore reverse if interest rates rise, as predicted by the market participants, cf. Box 11. The risk is supported by a tendency for many market participants to display uniform investment behaviour, partly because they are benchmarked against each other and apply similar market-based risk-management tools, and consequently an adjustment may be self-reinforcing.

A RISK INDEX FOR EURO-DENOMINATED ASSETS	Box 11
The development in the financial markets can be used to calculate a risk index for assets denominated in euro 1. The index is calculated on the basis of a number of credit spreads and implied volatilities, among other things. An increase in the index indicates that in the assessment of the market participants the level of risk in the markets has increased, and/or that the market participants are less willing to incur a given risk (whereby the price of the risk increases). It is seen that since 1999 the development in a number of factors has been linked to fluctuations in the risk index – an increase in the risk index is related to e.g. lower economic activity, higher macroeconomic uncertainty and higher official interest rates, as well as individual events such as the US accounting scandals in 2002.
A RISK INDEX FOR EURO-DENOMINATED ASSETS, 1999-2006
Note: For the calculation, see the footnote to the Box. Source: Bloomberg, J.P. Morgan and own calculations.
In recent years the risk index has fallen to a low level, cf. the Chart. This provides scope for substantial upward adjustment, in which case investors with higher-risk assets would incur losses compared with investors with lower-risk assets. Such adjustment might be initiated by official interest rates developing as the market participants expect since a positive correlation has previously been observed between the official interest rates and the risk index.
1 This Box is based on Jakob Lage Hansen, A risk index for euro-denominated assets, Danmarks Nationalbank, Working Paper, 36, 2006.

A number of products have been introduced that allow households to invest in e.g. commodities and government debt in emerging markets. Such investments have previously yielded high returns. However, there are no sure gains in the financial markets – high expected gains entail high risk^[8].

[1] Changes in the implied volatility may reflect changes in expectations of realised volatility, as well as compensation for uncertainty concerning future volatility.

[29 See Andersen, Hydeskov and Sand, Why are Long-Term US Yields Low?, Danmarks Nationalbank, Monetary Review, 4th Quarter 2005.

[3] Derived from options for interest-rate swaps.

[4] Changes in the implied volatility may reflect changes in expectations of realised volatility, as well as compensation for uncertainty concerning future volatility.

[5] The spreads between the yields on corporate and mortgage-credit bonds and a basket of euro area government bonds.

[6] General Motors and Ford are among the largest issuers of corporate bonds in the USA.

[7] For further details, see Jens Thomsen, Yield and Risk, Danmarks Nationalbank, Monetary Review, 3rd Quarter 2005.

[8] For further details, see Jens Thomsen, Yield and Risk, Danmarks Nationalbank, Monetary Review, 3rd Quarter 2005.