Summary of Quarterly Bulletin
February 2000

Research work published by the Bank is intended to contribute to debate, and is not necessarily a statement of Bank policy.

Recent developments in extracting information from options markets (83k)
(by Roger Clews, Nikolaos Panigirtzoglou and James Proudman of the Bank's Monetary Instruments and Markets Division).
The Monetary Policy Committee is provided with information from options markets to quantify market uncertainty about the future course of financial asset prices. For short-term interest rates, this is shown in the Inflation Report' s blue fan chart. Similar information can be obtained from a wide range of other assets. This article compares the performance of alternative techniques for extracting information from options prices. Using a technique for estimating uncertainty about interest rates at a constant horizon a short way into the future, we consider how this uncertainty has evolved since the Bank was granted operational independence in May 1997.

Virtually all financial assets pay out in the future. So the prices at which different assets trade can tell us something about the market's view of future states of the world. For example, the prices of bonds of different maturities contain information about the expected course of interest rates between maturity dates.

Options are contracts giving the right (but not the obligation) to buy or sell an asset at a point in the future at a price set now (the strike price). Options to buy (call options) are only valuable if there is a chance that when the option comes to be exercised the underlying asset will be worth more than the strike price. So if we look at options to buy a particular asset at a particular point in the future but at different strike prices, the prices at which such contracts trade now tell us something about the market's view of the chances that the price of the underlying asset will be above the various strike prices. So options tell us something about the probability the market attaches to an asset being within a range of possible prices at some future date.

Over the last few years, there has been considerable interest among academics, market participants and policy-makers in extracting information of this kind from options prices. The techniques used are described more fully in the article.

A common way of displaying the information extracted is as an implied risk-neutral probability density function (pdf) for the asset upon which the contract trades. In recent years, the pdfs used at the Bank have been estimated using a parametric technique, the mixture of two lognormals. The article reviews recent research carried out in the Bank to evaluate the performance of this technique. First, the quality of the data used to estimate pdfs is discussed. Next, the parametric technique is evaluated against a new non-parametric method, the 'smile interpolation'.

Research provides evidence that the non-parametric technique for estimating pdfs is an improvement upon the parametric one that has been used at the Bank over recent years. This conclusion mirrors a result found in tests on the yield curve.

A non-parametric technique can also be used to estimate pdfs over a constant-maturity horizon. As a simple example illustrates, this tool can be helpful for addressing questions such as the evolution over time of market uncertainty about the outlook for short-term interest rates. The article uses this technique to show that there has been little change overall since 1997 in the measure of market uncertainty, despite the sharp rise following the financial turbulence in Autumn 1998. There is also evidence of a fall in the probability the market attaches to sharp upward movements in rates.

It is intended in due course to make the data on pdfs available on the Bank's Internet site, at www.bankofengland.co.uk

Stock prices, stock indexes and index funds
(50k)
(by Richard A Brealey, special adviser to the Governor on financial stability issues).
In recent years, many UK investors have given up the quest for superior performance and have instead simply sought to match the returns on some broad market index. This has led to the suggestion that the growth in index funds has depressed the stock prices of those companies that are not represented in the index and has thereby increased their cost of capital. This effect may have been accentuated by the actions of fund managers, whose performance is compared with that of a market index and so who also have an incentive to avoid those stocks that are not included in the index. This paper argues that, in practice, these price effects are likely to be very small. In support of this view, the paper examines the price adjustments that occur when a stock is added to, or removed from, a stock market index.

Accumulating evidence that active portfolio managers do not achieve consistently superior performance has led to a rapid growth in index funds with low turnover and reduced management costs. For the most part, these funds track the performance of major market indexes and therefore tend not to be invested in the stocks of very small firms. This growth in index funds has forced active managers to hold a higher proportion of small-firm stocks than they otherwise would and, since they need to be induced to do this voluntarily, the expected return on these stocks must rise. This article argues that the portfolio adjustments forced on active managers are in practice very small and, since small-firm stocks are fairly good substitutes for large-firm stocks, the effect of index funds on required returns is likely to be no more than several basis points.

If market indexes are used as benchmarks for measuring the performance of professional active managers, then index stocks become effectively riskless for these managers and they need to be induced to hold the remaining stocks. Unlike index-fund managers, these active managers are not totally averse to holding non-index stocks, and so the incremental effect on prices of benchmarking is likely to be less than if these funds were formally indexed.

Most empirical studies of the effect on prices of index composition cannot distinguish the effect of index funds from that of benchmarking or possible information effects. One such study suggests that membership of the S&P index has had a substantial effect on prices in recent years, while another finds that flows into index funds have also had a marked cumulative price effect. However, it is difficult to reconcile these results with studies of the effect of additions or deletions to the index. In the United States these have typically found a price impact of around 3%, which would imply a shift in required returns of a few basis points. Our sample of changes to the FTSE All-Share and FTSE 100 indexes from 1994 to 1999 indicated that in both cases an addition to the index resulted in a negligible rise in price. Deletions, however, were associated with an eleven-day cumulative abnormal return of -4.5% for All-Share stocks and -2.0% for the FTSE 100 index. If permanent, these returns suggest that index deletions result in a small increase in the required return on equity for the affected firms. However, the fact that abnormal returns are observed for both indexes suggests that the effect is not simply due to the growth of index funds or performance benchmarking.

Private equity: implications for financial efficiency and stability (66k)
(by Ian Peacock and Stuart Cooper of the Bank's Domestic Finance Division).
This article describes the current state of the UK private equity market. It also considers the extent to which private equity promotes efficiency by facilitating the 'shake-up' of businesses, and whether the success of investment houses in attracting substantially increased funds for investment poses any threats to financial stability. Private equity comprises equity investment in all types of unquoted companies, whether provided by individuals, funds or institutions. The article concentrates on larger transactions (particularly management buy-outs and buy-ins of over £10 million), and excludes start-up and early-stage venture capital finance, which in effect forms a distinct market with different characteristics.

The growth in private equity investment in recent years has been strongly associated with the policy of many large companies to sell non-core subsidiary businesses. This has created a financing need that has partly been met by private equity. It has, in particular, helped businesses that have been neglected by their owners (or by the listed market) to raise capital for expansion. Private equity investors have, in effect, assumed the risks of supporting businesses through a period of major change. They are not long-term shareholders, however, and, for this reason, the private equity market is not an enduring alternative to a listing for the companies in question.

The private equity market is international. UK-based investment houses obtain much of their funding from overseas, especially from the United States. A number of American investment houses have also set up offices in London, as Europe is seen to offer attractive investment opportunities. The UK investment funds themselves are increasingly investing in continental Europe and to some extent in the United States.

There would seem to be no shortage of investment opportunities for private equity funds. Most large companies continue to maintain a 'back to basics' policy, which entails the disposal of non-core businesses. More fundamentally, technological and economic change creates continuing pressure for the restructuring of both companies and industries. The closer integration of the European market is, in particular, likely to give rise to considerable opportunities for restructuring and hence for private equity investment. The concerns that many smaller companies have expressed about the benefits of a listing have also opened up a new area for private equity investment. In short, the opportunities for private equity investment are unlikely to dry up in the foreseeable future.

Returns of more than 30% a year have attracted substantially increased inflows to private equity funds. These funds have intensified competition among investment houses, which may depress prospective returns. At the same time, the near-universal use of auctions to sell businesses has narrowed the scope for private equity investors to buy into businesses at clearly advantageous prices. These developments are putting pressure on the returns to be expected from private equity investments. They also mean that returns will, to an increasing extent, depend on investors bringing about efficiency improvements in the businesses in which they invest.

The pressure to maintain rates of return is changing the way that private equity houses operate. Many are becoming more pro-active in identifying investment opportunities, and have begun, for example, to look to mainland Europe. Some houses are becoming more involved in the operations of the businesses in which they invest. They are also becoming more ambitious in the scope of their transactions, looking to engineer mergers of companies to achieve cost savings. This will require them to acquire new skills-for example, in technical knowledge and hands-on industrial management.

Private equity is a relatively risky form of investment insofar as it typically relies on leverage for high returns. The current large overhang of uninvested funds has encouraged private equity houses to assume further risk in an effort to maintain their earlier, enviable track record. There were signs early in 1998, for example, that the prices paid for businesses by equity houses were on an upward trend and that structures were becoming more highly leveraged. However, the increased caution of banks in lending following the global financial turmoil of 1998 caused a cooling off, and a temporary closure in the nascent European high-yield debt market. The less turbulent conditions in 1999 encouraged a revival of high-yield debt, which is beginning to show signs of becoming an established form of finance. Some ambitious and complex financings have been seen recently and the pace of the market has increased, though some comfort might be taken from the fact that most of the lenders and investors are experienced professionals, not newcomers to the market.

The development of the private equity market and the levels of gearing that have accompanied it could, in principle, weaken the financial position of lenders. At present, the market is not large enough for this to appear to be a significant threat.