BIS Quarterly Review, March 2005
7 March 2005
The BIS Quarterly Review released today is divided into two parts. The first analyses recent developments in financial markets, financing flows in banking and debt securities markets, and activity in derivatives markets. The second part presents four articles: one on trading Asian currencies, another on time-varying exposures and leverage in hedge funds, a third on CDS index tranches and the pricing of credit risk correlations, and a fourth on contractual terms and CDS pricing.
Low yields in robust economies
Long-term yields in the major markets remained surprisingly low into the new year. Yields fell even as global growth prospects seemed to firm and the US Federal Reserve announced further increases in policy rates. With inflation expectations remaining stable, market participants frequently identified demand for long-dated assets by pension funds and insurance companies as a significant factor contributing to the low level of nominal yields.
Low yields continued to support investors’ appetite for higher-yielding instruments. Concerns that US policy rates might increase faster than had been previously expected caused corporate and emerging market spreads to widen slightly around the turn of the year. Nevertheless, by February, spreads had again narrowed to close to or below their historical lows. Equity markets followed a similar path, rallying up to the end of 2004 and then losing momentum in the new year. Mergers and acquisitions – or more generally the prospect of corporate releveraging – revived equity markets towards the end of January.
The international debt securities market
The fourth quarter of 2004 completed a banner year for international debt securities. Gross issuance of bonds and notes was $826 billion in the quarter, bringing the total for 2004 to over $3 trillion. This represents a 14.5% increase over 2003 and is a historical high relative to global GDP, indicating that borrowers had relatively easy access to credit markets last year.
The most significant increase in the fourth quarter was debt issued by the largest developed economies. Net issuance of all international debt securities rose by almost $80 billion and $19 billion in the euro area and the United States, respectively. In particular, high-yield issuance in developed economies remained at elevated levels. Meanwhile, issuance by emerging market entities reached its highest yearly total ever, as spreads on emerging market debt fell to historic lows.
Overall turnover of exchange-traded derivatives contracts was weak in the final quarter of 2004, as the combined value of trading in interest rate, stock index and currency contracts fell by 4%, to $278 trillion. The slowdown in activity came principally from the decline in the short-term interest rate segment in North America. Weak trading of short-term interest rate contracts was probably related to a greater convergence of views about the likely path of monetary policy in the United States.
Meanwhile, business remained solid for derivatives based on long-term interest rates and stock market indices, and grew significantly for currencies. For derivatives on long rates as well as stock indices, a fourth quarter decline in growth forecasts for 2005 may have stimulated greater hedging activity. The expanded business in currency-related contracts was probably a product of the sharp depreciation of the dollar and higher implied volatility, which have been associated with increased hedging activity and position-taking in the past.
The international banking market
Investment in international debt securities by BIS reporting banks drove the overall growth in claims in the third quarter of 2004. Purchases of these instruments by banks in the United Kingdom and the euro area were particularly strong, while Japanese banks continued to invest in US and euro area government securities. By contrast, the growth in loans to non-bank borrowers was positive but weak, and largely reflected new lending to offshore centres.
Overall, emerging market economies experienced a relatively large net outflow of funds, driven primarily by growth in deposits placed with BIS reporting banks. Such placements contributed to an outflow of funds from Asia-Pacific and the Middle East and Africa. A reduction in claims, as well as deposit placements abroad, was behind a net outflow from Latin America. In emerging Europe, strong growth in claims on the countries that had recently entered the European Union drove a small net inflow, despite relatively substantial deposit placements abroad by certain countries.
Trading Asian currencies
Trading in most major Asian currencies is growing even faster than the global total. Corrinne Ho, Guonan Ma and Robert McCauley from the BIS find that turnover in Asian currencies increased rapidly from 2001 to 2004 in relation to underlying trade in goods and services; both a global search for yield and a secular deepening in Asian financial markets contributed to this growth. Evolving expectations of the dollar/renminbi rate appear to be joining the dollar/yen and dollar/euro spot rates in exerting an influence on Asian foreign exchange markets. This evidence is at odds with the conventional wisdom that Asian currencies all trade in a dollar bloc, and instead suggests that most Asian currencies are increasingly trading with an effective exchange rate orientation.
Time-varying exposures and leverage in hedge funds
Hedge funds are distinguished by their flexibility, as well as their ability to rapidly leverage their exposure. Patrick McGuire, Eli Remolona and Kostas Tsatsaronis from the BIS utilise style analysis to uncover the risk factors that drive hedge fund returns and find that as market conditions change, so do the funds’ investment strategies. Hedge funds that belong to different style families have a marked degree of commonality in their risk exposures; for example, the three broad fund families considered in the article experienced similar changes in their risk exposures surrounding the equity market peak in 2000. The authors also construct a rough time-varying indicator of hedge fund leverage, which shows leverage to have been at its highest in late 1997–98, but more subdued over the past few years.
CDS index tranches and the pricing of credit risk correlations
One of the most significant new developments in financial markets in recent years has been the creation of liquid instruments that allow for the trading of credit risk correlations. Jeffery Amato and Jacob Gyntelberg from the BIS note that the standardisation of index tranches may prove to be a significant further step towards more complete markets, as it fills a gap in the ability of markets to transfer certain types of credit risk across individuals and institutions. The authors also note that standardised loss tranches based on credit default swap (CDS) indices are relatively liquid compared to other credit products. The authors document differences across tranches in market-implied default time correlations and suggest that these might reflect market segmentation, uncertainty about credit risk correlations, local demand conditions and/or the use of pricing models different from standard models.
Contractual terms and CDS pricing
As the market for credit default swaps (CDSs) has grown, the menu of contractual terms available to the parties to a CDS contract has expanded as well. The price changes associated with contractual distinctions can have significant implications for both markets and regulatory practice. Frank Packer and Haibin Zhu from the BIS find that CDS spreads tend to be significantly higher for those contracts with a broader definition of trigger events or fewer restrictions on deliverable obligations. Changes in the expected probability of default and changes in the expected losses-given-default both appear to have a significant role in pricing these differences, as theory would suggest. In addition, the valuation of contractual differences has generally converged over time, although there still appears to be evidence of a degree of regional fragmentation.