Structural changes in financial markets may be having a permanent dampening effect on volatility, which is in a long-term decline across various assets, the Bank for International Settlements said on Friday.
The BIS found that volatility of short and long-term interest rates, stocks, exchange rates and corporate spreads was low from mid-2004 to March 2006 simultaneously across different assets and markets, in industrial countries and emerging market economies.
"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," it said.
"The results suggest that important drivers of the volatility reduction seem to be structural, and may therefore have a permanent effect on volatility," the BIS said in a paper.
The Basel-based BIS, a forum for central banks world-wide, said in most countries current bond market volatility is 20-30 percent lower than past averages, while stock market volatility has declined more than bond market volatility. Volatility in the foreign exchange market has been also low, hitting record lows in some euro cross pairs.
The bis said the dampening volatility effect came roughly from the following Factors:
SUSTAINED ECONOMIC EXPANSION AND LOW INFLATION: At the macroeconomic level, financial volatility is typically countercyclical. It is also related to fluctuations in risk aversion as investors tend to be more risk averse during recessions.
"The recent fall in asset price variability may... reflect the ongoing phase of sustained expansion and low inflation experienced by the world economy," the bank said. "Because GDP volatility is relatively high during recessions, high financial volatility tends to be associated with weak economic conditions."
LIQUIDITY AND FINANCIAL MARKETS: Volatility is also affected by the structure of financial markets. The growth in transaction volumes in the cash markets, which are at the highest levels for the last decade, has improved market liquidity.
The rapid growth of the market for risk transfer instruments, which allow investors to hedge or unwind exposures quickly without trading in the cash market, has also contributed.
The growing role of hedge funds in recent years also raised market liquidity.
Some changes taking place in the US mortgage-backed securities market have helped reduce hedging-related volatility, with potential spillover effects on long-term debt denominated in other currencies.
Since 2004 there has been a considerable increase in the supply of options, offering protection from financial risks from hedge funds, investment banks and pension funds. Financial market integration has also increased risk sharing opportunities, thus reducing the level of risk.
CENTRAL BANKS: Many central banks have striven in recent years to reduce the uncertainty arising from policy decisions. One important element has been the trend towards gradualism in policy action. Another key factor has been the recent increase in central bank transparency. The BIS noted that central banks of New Zealand and Norway had recently decided to publish expected paths for their own policy rates.
"Forward-looking communication helps ensure that long-term interest rates and other asset prices do not build in a projected pace of policy action that differs from that anticipated by policymakers."
IMPROVEMENTS IN CORPORATE BALANCE SHEET: The recent decline in volatility may be related to improvements in the balance sheet conditions of listed companies.
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