Quarterly Review, March 2006

The BIS Quarterly Review released today is divided into two parts. The first presents an overview of recent developments in financial markets, before turning in more detail to financing flows in banking and debt securities markets, and activity in derivatives markets. The second part presents four articles: one on the new BIS effective exchange rate indices; another on new developments in the system of US housing finance; a third on the euromarket experience with basket currency bonds; and a fourth on the use of information from option prices to derive risk premia across asset markets.

Emerging markets soar to historical highs

Asset prices in emerging markets rallied to record highs early in the year. Foreign investors were eager buyers of emerging market bonds and equities, pushing indicators of valuations towards and in some cases beyond the upper end of their historical range. The steady improvement in many countries' fundamentals contributed to investors' enthusiasm for emerging market assets. Investors' heightened appetite for risk also appeared to be an important factor behind the rally.

In the major markets, investors were less exuberant. They seemed uncomfortable with current valuations in equity and corporate bond markets but at the same time uncertain in which direction to take a position. In the United States, interest rates, oil prices and corporate earnings all weighed on equity prices. In Japan, seemingly idiosyncratic events had market-wide repercussions, bringing a temporary halt in January to the rally on the Tokyo exchange. Shareholder-friendly actions such as leveraged buyouts continued to loom over corporate debt markets, but corporate spreads remained stable near their cyclical lows despite the associated risks.

In government bond and swap markets, yields advanced despite mixed news on the economy, as traders expected monetary policy to tighten further in the United States and Europe. In Japan, as inflation turned positive, market participants expected the policy of quantitative easing to be abandoned earlier than previously anticipated.

The international debt securities market

Global gross issuance of international bonds and notes increased by 25% in the fourth quarter of 2005, even though the fourth quarter is usually the quietest in the international debt issuance calendar. Borrowing by emerging market countries remained strong, closing out a record-breaking year in which gross issuance rose by more than 50%. Emerging market borrowers evidently took advantage of very favourable financing conditions throughout most of the year, including the narrowing of spreads to new historical lows. By contrast, high-yield issuance in developed economies declined during the quarter, despite spreads holding steady throughout the period.

Global net issuance of bonds and notes more than doubled in the fourth quarter, rising from $237 billion to $572 billion. Net issuance grew significantly amongst US, UK, euro area and emerging market borrowers. In particular, net borrowing by Freddie Mac increased more than threefold in the period.

Derivatives markets

Trading on the international derivatives exchanges declined during the fourth quarter of 2005. Combined turnover (measured by notional amounts) in fixed income, equity index and currency contracts fell by 4% quarter-on-quarter to $344 trillion. As in the previous quarter, this was mainly due to seasonal factors, which tend to depress activity in the interest rate segment towards the end of the year. The year-on-year rate of growth remained unchanged at 22%.

In the interest rate segment, weaker activity in the US and Japanese markets was partially offset by increased turnover on short-term euro interest rates ahead of the ECB's rate hike on 1 December. Turnover in stock index contracts in the fourth quarter rose by 14% to a record $39 trillion, with growth concentrated in contracts on Japanese and US stock indices. The volume of exchange-traded currency contracts increased by 8% to $3.3 trillion. Trading in commodity derivatives increased slightly during the final quarter of 2005, as a large rise in the turnover of contracts on precious metals was offset by reduced activity in energy derivatives.

The international banking market

Total cross-border claims continued to expand in the third quarter of 2005, although at a somewhat slower pace than in the previous two quarters. Interbank activity accounted for over half the total rise in cross-border claims, with greater claims on non-banks in offshore centres also contributing. Credit to non-bank borrowers in the United States also rose noticeably, driving a fifth consecutive quarter of strong growth in total claims on non-banks.

Major oil-exporting countries continued to recycle a portion of their oil revenues through BIS reporting banks. In addition, banks in Asia, including some central banks, deposited funds in banks abroad. Combined, these placements overshadowed greater lending to borrowers in emerging Europe and Asia-Pacific, and were behind an overall net outflow of funds from emerging markets.

The new BIS consolidated banking statistics – which quantify the foreign exposures of internationally active commercial banks – now contain information on reporting banks' derivatives and contingent claims. As of the third quarter of 2005, the stock of these claims stood at nearly 40% of the exposure in standard loan and securities claims. The stock of derivatives and contingent claims on emerging economies tends to be larger where the banks have an established presence via loans and securities.

Special features

The new BIS effective exchange rate indices

An effective exchange rate (EER) provides a better indicator of the macroeconomic effects of exchange rates than any single bilateral rate. Therefore, measures of EERs are essential for both policymakers and market participants. Marc Klau and San Sau Fung of the BIS describe the main features of the new BIS EER indices, including the expansion of the coverage to a larger number of economies, the adoption of time-varying trade weights, and special adjustments to account for mainland China's indirect trade with the rest of the world via Hong Kong SAR. After comparing the updated indices with the BIS's previous ones, the authors conclude that the new weights better represent trade flows, and should improve the usefulness of the BIS EER indices as reliable indicators of exchange rate movements and their impact. The newly calculated indices have been made available to the public on the BIS website.

Prime or not so prime? An exploration of US housing finance in the new century

The system of US housing finance has changed profoundly in recent years, with securitised loans to non-prime borrowers accounting for a steadily increasing share of US housing finance. In addition, mortgage markets have become even more dependent on credit scoring techniques to differentiate between borrowers. Allen Frankel of the BIS documents how new mortgage products are much more prevalent in strong real estate markets. Frankel notes that, as a result of all these developments, many households now have greater access to housing finance. But were housing market conditions to worsen, investors in many mortgage-backed securities could face new challenges in their valuation and possibly unanticipated risks.

Basket weaving: the euromarket experience with basket currency bonds

The market use of baskets of European currencies has frequently been cited as a possible precedent for regional bond market development in Asia. Robert McCauley of the BIS and Clifford Dammers, former Head of Regulatory Policy at the International Capital Market Association, review the record of basket issuance in the euromarket in the decades before the inception of the euro in 1999. The authors argue that ECU-denominated international bonds owed their limited success in the 1980s and 1990s more to restrictions on the internationalisation of the Deutsche mark and to speculative investment than to the benefits of diversification. McCauley and Dammers conclude that the prospective policy gains from basket issuance must be weighed against the possible loss of liquidity in domestic bond markets.

Risk premia across asset markets: information from option prices

Financial market commentary often focuses on the identification and analysis of risk premia – or the compensation required by investors for risk – embedded in asset prices. Nikola Tarashev and Kostas Tsatsaronis of the BIS combine information from US equity and money market option prices to derive measures of risk premia in both markets that are consistent with a single price of risk. The authors find these measures of risk premia to be positively correlated with measures of risk, and negatively correlated with past market returns. Tarashev and Tsatsaronis conclude that consistent estimates of risk premia can be useful in interpreting financial market conditions and assessing near-term prospects in securities markets.