A new paper published by the Bank of International Settlements examines the phenomenon of lower financial volatility, considering whether the reduction is permanent or temporary, and the consequences for markets.

The BIS paper studies the behaviour of financial market volatility since 1970, with special emphasis on the evolution in recent years. It notes that, “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 paper finds that 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. However, if the sample period is extended back to the last two to three decades, other periods in which volatility reached similar low levels can be observed, it adds. “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,” it says.

The study suggests that firm-specific components of volatility seem to have become more important over time. It finds evidence to support, “the hypothesis that the recent decline in volatility may be related to improvements in the balance sheet conditions of listed companies… 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, it adds. “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),” it notes.

Some of the changes taking place in the US market for mortgage-backed securities have contributed to reducing hedging-related volatility, it says, “with potential spillover effects on long-term debt denominated in other currencies.”

It also says that since 2004 there has been a considerable increase in the supply of options 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,” it says.

The report also emphasizes a trend among central banks towards increased gradualism in policy action, 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,” it says, which reduces “technical volatility”.

The results of the study 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… as well as the changes in monetary policy,” it explains. “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, then its effect on volatility may also turn out to be permanent.”

However, it allows that some of the volatility-dampening factors might be reversed in the future. “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,” it cautions. “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.”

The report says that financial markets seem to believe that the reduction in volatility is partly 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.”

@page_break@An increase in volatility, however, does not necessarily imply that there is deterioration in financial conditions, the BIS paper says. “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.”