The recent behaviour of financial market volatility
BIS Papers No. 29
August 2006
bis.org
Introduction and executive summary
A striking feature of financial market behaviour in recent years has been the low level of price
volatility over a wide range of financial assets and markets. The issue has attracted the
attention of central bankers and financial regulators due to the potential implications for
financial stability. This paper makes an effort to shed light on this phenomenon, drawing on
literature surveys, reviews of previous analyses by non-academic commentators and
institutions, and some new empirical evidence.
The paper consists of seven sections. Section 2 documents the current low level of volatility,
putting it into a historical perspective. Section 3 briefly reviews the theoretical determinants of
volatility, with the aim of helping the reader through the subsequent sections of this Report,
which are devoted to the explanations of the phenomenon under study. These explanations
have been grouped into four categories: real factors; financial factors; shocks; and monetary
policy. Thus, Section 4 looks into the relation between volatility and real factors, from both a
macro- and a microeconomic perspective. Section 5 considers how the recent developments
in financial innovation and improvements in risk management techniques might have
contributed to the decline in volatility. Section 6 considers the relation between real and
financial shocks and volatility. Finally, Section 7 explores whether more systematic and
transparent monetary policies might have led to lower asset price volatility.
Recent patterns in volatility
The evidence presented in this Report shows that over the period from mid-2004 to March
2006 the volatility of short-term and long-term interest rates, stocks, exchange rates and
corporate spreads has been generally low relative to the previous five to 10 years in both
industrial countries and emerging market economies (EMEs). However, if the sample period
is extended back to the last two to three decades, for which daily data are available, other
periods in which volatility reached similar low levels can be observed. The exception is
represented by the volatility of short-term interest rates, which has reached its lowest level
for 20 years in all the main currency areas.
A distinguishing feature of the period analysed is that volatility has been low for a prolonged
period simultaneously across different assets and markets, in industrial countries and
EMEs alike.
The impact of the fall in volatility observed at the individual market/asset level on the
variation of returns experienced by investors holding global portfolios may have been
mitigated by the apparently increased tendency of domestic bond and stock markets to
co-move. In spite of this, the volatility of global portfolios is subdued.
Measures of volatility based on monthly stock and bond prices, available since the second
half of the 19th century, reveal that since the 1970s volatility in the major industrialised
countries has been on average higher than in the previous 100 years: the current level of
volatility is not low in a historical perspective.
Why did volatility decrease?
Several factors may have contributed to the recent decline in asset price volatility. At the
macroeconomic level, a number of theoretical and empirical studies suggest that financial
volatility is typically countercyclical: the recent fall in asset price variability may thus reflect
the ongoing phase of sustained expansion and low inflation experienced by the world
economy. Another macroeconomic factor - of a more structural nature - explaining lower
volatility may be represented by the so-called “Great Moderation” - the fact that, since the
mid-1980s, output growth has become noticeably less volatile, especially in the United
States. However, the Great Moderation is an unlikely candidate to explain the recent phase
of low volatility, largely because it emerged well before the decline in volatility. Still, there is
some preliminary evidence that the volatility of GDP growth and (to a lesser extent) of
inflation may have continued to decline over the last 15 years, especially in some countries,
and that part of this further decline may have occurred since 2004.
The firm-specific components of volatility seem to have become more important over time.
The theoretical and empirical results surveyed in this Report suggest that volatility is
negatively related to firm profitability, and positively related to leverage and to uncertainty
about profitability. The graphical analysis presented in Section 4 is thus broadly supportive of
the hypothesis that the recent decline in volatility may be related to improvements in the
balance sheet conditions of listed companies: around 2003-04 a decline in leverage and an
improvement in actual and expected profitability can be observed in most industrialised
countries. Furthermore, surveys suggest that over the same period the degree of uncertainty
surrounding firms’ profitability also decreased.
Developments in financial markets may also have contributed to the decline in volatility.
Foremost is the improvement in market liquidity, which has benefited from the growth in
transaction volumes in the cash markets (now at the highest levels for the last decade), from
the rapid growth of the market for risk transfer instruments (which allow investors to hedge or
unwind exposures quickly without having to trade in the cash market) and from the growth of
the fraction of assets held by well informed agents managing diversified portfolios, such as
institutional investors (eg pension funds, hedge funds). Some of the changes taking place in
the US market for mortgage-backed securities (eg greater use of static hedging, growing
popularity of adjustable rate mortgages) have contributed, starting in 2004, to reducing
hedging-related volatility, with potential spillover effects on long-term debt denominated in
other currencies. Finally, according to market commentary, since 2004 there has been a
considerable increase in the supply of options (offering protection from financial risks) from
investors such as hedge funds, investment banks and pension funds. This has brought
downward pressure on option prices, thus reducing implied volatility, with a possible
feedback to realised volatility.
The evidence summarised in this Report is not supportive of the so-called “good luck
hypothesis” - the possibility that the current phase of low volatility is simply due to the
absence of relevant shocks. In fact, since the summer of 2004 the global economy has been
affected by a number of adverse shocks, both economic (oil price increases, credit
deterioration in the US car industry) and geopolitical (terrorist attacks, natural disasters, war).
Important changes and improvements in the conduct of monetary policy over the recent
past seem to have played a key role in reducing the volatility of at least some interest rates.
The Report emphasises a trend among central banks towards increased gradualism in policy
action (more frequent policy moves of smaller size), greater transparency, improved
communication about policy intentions, and improvements in the operational framework.
These translate into more stable money market rates and, to a much lesser extent, long-term
rates. Preliminary evidence for the United States and the euro area indicates that over the
last two years the transmission of “technical” volatility from the money market to longer-term
maturities has been curtailed. While the causes of this change remain to be ascertained, it is
plausible that it is related to increased central bank predictability.
Is the reduction in volatility temporary or permanent?
A key issue is whether the current low level of volatility is a permanent new feature of
financial markets or only a temporary phenomenon.
The results suggest that important drivers of the volatility reduction seem to be structural,
and may therefore have a permanent effect on volatility. These include some of the
changes in the financial sector surveyed above (improved market liquidity, greater role of
institutional investors, changes in the US market for mortgage-backed securities), as well as
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the changes in monetary policy mentioned earlier. Moreover, to the extent that the
strengthening of the balance sheets of listed firms reflects a cross-country restructuring of
the corporate sector independent of the economic cycle (reaping the benefits of the “new
economy”, not only in the United States but also in the euro area and Japan), then its effect
on volatility may also turn out to be permanent.
However, conjunctural factors have also played a role, suggesting that part of the
volatility reduction might be reversed in the future. First of all, to the extent that cyclical
factors played a role in containing volatility, some increase should be expected in the event
of a slowdown of the world economy. Moreover, if the volatility decline partly reflects an
increased supply of options, it could reverse as soon as investors find alternative, more
attractive opportunities. Finally, a monetary policy-related factor, which may have contained
volatility in the recent past, may contribute to raising it in the future. As policy rates are
already near a “neutral level” in the United States, and at the point when they will be so in
other countries, the consequent increased uncertainty about future policy moves (a resumed
“two-way risk”) may entail higher uncertainty about short-term rates, with possible spillover to
longer rates and other asset classes.
Financial markets seem to concur with the view that the reduction in volatility is in part
temporary. For example, despite the prolonged period of low volatility, the equity premium
implied in stock prices does not seem to have declined. If the reduction in the volatility of
stock returns turns out to be of a more permanent nature, sooner or later the equity premium
will have to adjust downwards, implying a permanently higher equilibrium level of stock
prices.
Implications for financial stability
The level of volatility in financial markets can influence the corporate sector’s investment
decisions and bank’s willingness and ability to extend credit facilities. In this context one
question that is sometimes raised is what impact changes in the volatility level might have on
financial stability. This Report emphasises that the reduction in volatility represents to a
considerable extent the consequence of improvements in the functioning and structure of
global financial markets: increased market liquidity, the greater role of institutional investors,
better communication between central banks and financial markets, and stronger company
balance sheets have all contributed to enhancing investors’ ability to avoid shocks or to deal
with them, pushing volatility down. In this respect, the current low levels of volatility are
associated with improved financial conditions.
An increase in volatility, however, does not necessarily imply that there is deterioration in the
financial conditions. Although financial instability is usually followed by heightened volatility,
the reverse is not generally true. The effects of an increase in volatility levels on financial
conditions will depend on the extent, speed and pervasiveness of the volatility increase.
Because risk management practices have improved considerably in recent years, financial
institutions are better equipped now to mitigate undesirable effects of large increases in
volatility than in the past. |
