# Evidence of risk tolerance returning, says BIS

The BIS reported that financial markets have, since mid-March, rebounded from an extended period of illiquidity and low asset valuations, factors that decimated the balance sheets of major institutions after the credit crisis took hold last August. Repeated central bank intervention and the Federal Reserve Bank's role in the takeover of Bear Stearns by JP Morgan were cited as contributory factors to the recent recovery.

The last quarter saw credit spreads rally to mid-January levels, before fluctuating around these valuations throughout May. Between the end of February and the end of May, the US five-year CDX high-yield index tightened by approximately 144 basis points to 573bp, while corresponding investment-grade spreads fell by 63bp to 102bp. European and Japanese spreads broadly mirrored the performance of the major US indexes, declining by between 25bp and 153bp overall.

Meanwhile, first-quarter volumes on international derivatives exchanges showed substantial growth, driven mainly by activity in short-term interest rate derivatives.

The total turnover based on notional amounts increased to $692 trillion from the$539 trillion recorded in the fourth quarter of 2007. The latest quarter’s figures represent the highest turnover on record and a rise of 30% over the corresponding period in 2007.

Turnover in short-term interest rate derivatives rose to $548 trillion in the first quarter of 2008 from the previous quarter’s$406 trillion, and also showed year-on-year growth of 32%. “The increase was mostly accounted for by currency segments that had recorded a significant retreat in the fourth quarter of 2007,” the BIS report said.

Volumes in foreign exchange derivatives traded on exchanges also showed a 32% increase over the corresponding period last year. Turnover rose to $6.7 trillion from$6.0 trillion in the previous quarter. The BIS attributed the increase mainly to trading on the euro, yen and Swiss franc, which offset a decline in currencies including the Canadian dollar and sterling.

Meanwhile, activity in equity derivatives fell slightly in the first quarter of 2008 to $73 trillion from$75 trillion in the previous quarter. Despite this, the year-on-year growth rate was 22%. By currency denomination, Korean won-denominated equity derivatives contracts declined the most, followed by Indian rupee and sterling contracts, while the largest increase originated from euro- and dollar-denominated contracts.

The over-the-counter derivatives market has also experienced significant growth. Notional amounts of all categories of OTC contracts increased by 15% to $596 trillion for the second half of last year, following a 24% increase in the first half of 2007. “Growth was particularly strong in the credit segment, due possibly to heightened demand for hedging credit exposure,” said the report. Notional amounts of credit default swaps expanded by 36% in the second half of 2007 to$58 trillion, although this was proportionately less than the 49% rise recorded in the first half of the year.

Notional amounts of OTC foreign exchange derivatives increased 16% in the second half of 2007. Contracts with one component currency denominated in either US dollars, euros, yen or Swiss francs showed particularly robust growth rates of between 16% and 21%.

The notional amount of OTC interest rate derivatives grew 13%. By contrast, the notional amounts of OTC equity derivatives decelerated to –1% in the second half of the year from a growth rate of 15% in the first half of 2007, the lowest pace of growth reported since the second half of 2004.

In contrast to developments in other markets, interbank money markets have continued to show signs of stress in the past quarter. Spreads between Libor rates and corresponding overnight index swap rates were generally at least as high at the end of May as they had been three months earlier. BIS attributed the trend, evident in the US, Euro and UK markets, to concerns over counterparty credit risk and liquidity.

“This appeared to imply expectations that interbank strains were likely to remain severe well into the future,” said the report.

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