Quarterly Bulletin
Financial Markets Articles

Recent developments in portfolio insurance (2.2mb)
By Darren Pain of the Bank's Foreign Exchange Division and Jonathan Rand of the Bank's Sterling Markets Division.
The aim of this article is to describe how portfolio insurance works, the main strategies employed and how these have evolved over recent years, and the possible links between their use and financial market stability. The key benefit of portfolio insurance is that it enables financial risk to be distributed among those agents most willing to absorb it. The downside is that it can possibly create conditions for greater fragility in financial markets and leaves issuers of portfolio insurance exposed to potential unexpectedly high losses. It seems unlikely that portfolio insurance-related investments contributed significantly to the financial market volatility that began in Summer 2007. Nonetheless, it is important to keep alert to situations when portfolio insurance could potentially work to amplify financial market instability.

Recent developments in sterling inflation-linked markets (620k)
(By Grellan McGrath and Robin Windle of the Bank's Sterling Markets Division). Sterling inflation-linked markets have developed rapidly over recent years, both in size and complexity. These changes have been driven by increased demand, especially from institutional investors such as pension funds, which has stimulated new supply as well as the rapid development of the market for inflation swaps. This article surveys these developments and considers their implications, in particular for the way risk is transferred between market participants and the interpretation of observed market rates. Market contacts suggest the increases in activity and the number of participants have enhanced efficiency in these markets, although the timing of demand and supply flows can still influence observed market prices. Looking ahead, there are considerable uncertainties as to the size of future demand and supply in the market.

Understanding the term structure of swap spreads (547k)
(by Fabio Cortes of the Bank's Foreign Exchange Division). Market expectations about the future path of interest rates can be derived from both government bond and swap yield curves. But at times these curves may provide imprecise signals about interest rate expectations. Understanding what factors can affect the term structure of swap spreads - the difference between government bond rates and swap rates at different maturities - may therefore be helpful to policymakers when interpreting market views of future interest rate developments.
This article reviews past developments in dollar, euro, sterling and yen government bond and swap markets and considers the potential influences on the term structure of swap spreads. Using statistical analysis, it finds that some influences seem to be common across international markets, but others, such as liquidity or preferred habitat issues, tend to be specific to certain markets.

The information content of aggregate data on financial futures positions (327k)
(by Caroline Mogford of the Bank's Sterling Markets Division and Darren Pain of the Bank's Foreign Exchange Division). This article uses statistical analysis to investigate the strength of any empirical relationships between data on speculative financial futures positions and movements in asset prices. It finds strong evidence that speculative positions do indeed tend to move closely with changes in the underlying asset prices. But there is little support for the view that these positions data systematically inform about future changes in asset prices.

The forward market for oil (100k)
(by Patrick Campbell of the Bank's Foreign Exchange Division, Bjorn-Erik Orskaug of the Bank's International Finance Division and Richard Williams of the Bank's International Economic Analysis Division). As the spot price of oil has risen in recent years, so has the price of oil for delivery in the future. This article examines the workings of the forward market for oil and considers why producers have not been hedging more of their future oil production following these unusual forward price moves.

Do financial markets react to Bank of England communication? (294k)
(by Rachel Reeves of the Bank’s Structural Economic Analysis Division and Michael Sawicki of the Bank’s External Monetary Policy Committee Unit). Communication by the Bank of England’s Monetary Policy Committee (MPC) can convey information to market participants about the economic and policy outlook. In an inflation-targeting framework, clear communication by the central bank has an important role in explaining interest rate decisions and in helping to anchor inflation expectations. This article explores how financial markets react to different forms of communication by the MPC. The article finds that markets react to collective forms of communication such as the MPC Minutes and Inflation Report. But reactions to what might be called individual forms of communication - speeches and testimony to parliamentary committees - are more difficult to discern. Compared with a similar study for the United States, the results for the United Kingdom are less pronounced.

Over-the-counter interest rate options (96k)
(By Richhild Moessner of the Bank's Gilt-edged and Money Markets Division). The Bank of England's Monetary Policy Committee uses market expectations of future interest rates to inform its policy decisions. Interest rate expectations can be inferred from a range of financial instruments, including interest rate options. This article surveys the structure and use of the over-the-counter (OTC) interest rate option market. It discusses what information OTC interest rate options may contain about market interest rate expectations, additional to that available from products traded on exchanges. It also considers the linkages between OTC interest rate option markets and the markets in the underlying assets.

Interpreting movements in high-yield corporate bond market spreads (162k)
(by Neil Cooper, Robert Hillman and Damien Lynch of the Bank's Monetary Instruments and Markets Division). Spreads of corporate bond yields over risk-free rates are often used as a leading indicator of macroeconomic conditions. The large widening of spreads within the US high-yield bond market during the second half of 2000 might be a precursor of a downturn in the US economy.

Credit spreads in the United States widened considerably during 2000, particularly in the high-yield bond market. Even indices of single-A and AA rated bonds widened in the last few months of the year. By contrast, with the exception of telecoms bonds, there was little evidence of widening in UK credit spreads. In this article we explain why US spreads widened, and assess the implications for the US macroeconomic outlook.

Sterling wholesale markets: developments in 2000
(136k)
Sterling wholesale markets grew by 5% in 2000, less quickly than in 1999. The money, corporate bond and swap markets continued to expand, whereas the amount of gilt-edged stock outstanding was broadly unchanged. Liquidity in sterling markets stabilised during the year; in some markets turnover and liquidity increased. Government cash management transferred to the UK Debt Management Office; the Bank of England's open market operations continued as before.

Inferring market interest rate expectations from money market rates (192k)
(by Martin Brooke of the Bank's Gilt-edged and Money Markets Division, and Neil Cooper and Cedric Scholtes of the Bank's Monetary Instruments and Markets Division). The Bank's Monetary Policy Committee (MPC) is interested in financial market participants' expectations of future interest rates. Knowledge of such expectations helps the MPC to predict whether a particular policy decision is likely to surprise market participants, and what their short-term response is likely to be to a given decision. Expectations of future levels of official rates also play a key role in determining the current stance of monetary policy. The Bank implements the MPC's monetary policy decisions by changing the level of its two-week repo rate which, in turn, influences the levels of other short-term money market interest rates. However, many agents in the economy are also affected by changes in longer-term interest rates. For instance, five-year fixed-rate mortgages are typically priced off the prevailing rates available on five-year swap contracts, and larger firms often raise finance in the capital markets by issuing long-maturity bonds. Changes in these longer-term interest rates depend to a considerable extent on expectations of future official rates. So the Bank needs to have some understanding of expectations of future policy rates, in order to monitor and assess changes in current monetary conditions.

Forward rates are the most commonly used measure of interest rate expectations. In principle, we want to derive forward rates that correspond to future two-week Bank repo rates. Unfortunately, however, there is no instrument that allows us to do this exactly. So we have to estimate forward rates from the sterling money market instruments that are actually traded.

This article argues that first, forward rates estimated from money market instruments are biased estimates of expectations of future Bank repo rates because of term, credit and liquidity premia, as well as contract specification differences. And second, no particular money market instrument is likely to provide a 'best' indication of Bank repo rate expectations at all maturities. The spreads between the Bank's two-week repo rate and the instruments used to estimate our market curves are volatile and so we cannot expect to get a result that is common across all instruments. Reflecting these considerations, the Bank estimates two forward curves: one employing GC repo and gilt data and one that uses a combination of sterling money market instruments that settle on Libor rates. A number of simple ready-reckoner adjustments can be applied to the two estimated forward curves in an attempt to transform them into an estimate of a forward curve equivalent to two-week Bank repo rates. First, the GC repo/gilt forward curve needs to be adjusted up by around 15 basis points and the bank liability curve adjusted down by around 20 basis points. After these changes we still need to consider the impact of term premia effects. Preliminary estimates suggest that this would require us to make a further downward adjustment to both curves beyond a six-month horizon. However, we currently have limited information on the size of the term premia that create biases in forward curves even after we have taken into account estimates of credit and liquidity premia.

Financial market reactions to interest rate announcements and macroeconomic data releases
(47k)
(by Andrew Clare and Roger Courtenay of the Bank's Monetary Instruments and Markets Division). At 11.00 am on 6 May 1997 the new UK government announced that it had granted the Bank of England operational independence with respect to the implementation of monetary policy, subject to an RPIX inflation target of 2½% per year. This change was designed to improve the credibility and transparency of the monetary policy process. The Bank of England's aims were stated clearly, and the voting record and discussions of the members of the Monetary Policy Committee (MPC) were to be published shortly after interest rate decisions had been made.

Our aim in this study is to investigate whether there has been a systematic change since Bank independence in the way that market participants incorporate information from monetary policy announcements, and from other important macroeconomic data announcements, into financial prices. We use intra-day price data (rather than daily data, which are sometimes used in this context) because markets receive many different pieces of news throughout the trading day, and so the impact of a particular announcement may be obscured by using daily price series. We therefore concentrate on the minutes immediately preceding and following these announcements.

Our study uses high-frequency data on short and long-term LIFFE interest rate futures contracts, on the LIFFE FTSE 100 stock index futures contract, and on the dollar/sterling and Deutsche Mark/sterling exchange rates. We monitor the behaviour of these financial prices around the times of interest rate announcements and key macroeconomic data releases over two periods: from January 1994 to 6 May 1997 (pre Bank independence), and from 7 May 1997 to June 1999 (post Bank independence).

Our empirical results do not yield simple definitive conclusions about whether monetary policy is now better understood by financial market participants as a result of Bank independence. The total (cumulative) reaction of the LIFFE contracts and exchange rates to interest rate decisions appears either unchanged or lower in the post Bank independence period, depending on the market observed. This supports the idea that the news content of monetary policy announcements has fallen. However, while the total reaction supports this view, the immediate reaction in the first 5 minutes is larger in all of the markets studied here. With respect to interest rate decisions, it appears that the news contained in the decisions is incorporated into financial prices more quickly than in the pre Bank independence era. One possible explanation for this is that pre-positioning in the financial markets ahead of the decision has become more sophisticated since Bank independence, with the publication of a clear, unambiguous timetable for the announcement of interest rate decisions.

Looking at exchange rate responses, there is evidence to support the idea that FX market agents now pay more attention to macroeconomic data announcements. This evidence appears to suggest that the underlying economic data have become more important in these markets relative to the key monetary policy announcement.

A different picture emerges when we consider the impact on the LIFFE contracts of the same set of non monetary policy related announcements. For the short sterling and long gilt contracts these reactions are lower in the post Bank independence period. Since the total impact of interest rate announcements is also lower following May 1997, it is difficult to make any clear statements about the relative importance of monetary policy for LIFFE fixed-income market participants. We can say that all announcements now appear to have a lower impact upon the two interest rate contracts that we consider. Finally, there is a significant decline in FTSE 100 volatility around the set of macroeconomic announcements.

The empirical analysis presented is based on a relatively short sample, including a period when the markets will have been learning about the new monetary policy framework. The results can only be suggestive rather than the basis for firm conclusions. Nevertheless, there is some evidence that interest rate announcements have become less important for some financial markets, and no more important for others, since May 1997.

Common message standards for electronic commerce in wholesale financial markets (59k)
(by Bob Hills of the Bank's Market Infrastructure Division). An important aspect of electronic commerce is the potential for market participants to automate transaction processing fully, from the point of trade to final settlement. Such ‘straight-through processing’ could make wholesale financial markets more efficient, and lower the costs and risks that participants face. But it requires participants to use common message standards to exchange transaction data electronically. This article describes some of the initiatives to establish common message standards.

The development of common standards is central to the move towards automated processing of trade data and the wider adoption of electronic commerce in wholesale financial markets. This automation is expected to bring significant efficiency gains, as well as a reduction in costs and risk. Initiatives led by market participants to establish common standards have made considerable progress.

But it remains the case that too many trades in today's financial markets are still processed using fax or incompatible electronic networks. Standard-setting bodies continue to face difficulties in their efforts to gain widespread adoption of common and compatible message standards over the life of a trade.

Competitive pressures may force common standards to be adopted more widely if they are associated with new technologies that give market participants new ways to reduce costs or improve services.

The impact of XML, in particular, could be considerable. It has the potential to address some of the traditional failings of standards-that they are either too rigid, and do not reflect the needs of a particular market, or else that they are so flexible that they barely constitute a standard. It may also facilitate technological progress, by reducing firms' switching costs and so lowering barriers to entry and barriers to change. But this is likely to happen only if market participants work together to ensure that the XML-based standards that they create are inter-operable.

The precise ways in which electronic commerce and the development of common message standards will affect market structure in the medium term are difficult to predict. But it is clear that changing technology has the potential to bring about significant changes: to the ways in which markets operate and to the roles of market participants.

A comparison of long bond yields in the United Kingdom, the United States, and Germany (96k)
For most of the past 30 years, investors have demanded a higher nominal rate of return on UK government bonds (gilts) than on either German or US government bonds (Bunds and Treasuries respectively). The gilt-Treasury and gilt-Bund spreads reached a peak of around 8 percentage points in 1976 (using quarterly data). Since then, however, the size of this yield premium on gilts has declined steadily; in February 2000, the redemption yield on the 5¾% Treasury Stock 2009 (the current benchmark ten-year gilt) fell below the comparable German Bund yield. Furthermore, longer-maturity gilt yields are now well below comparable Bund and US Treasury yields.

This article begins by outlining the main determinants, according to economic theory, of these changes in relative bond yields. It then goes on to discuss what other UK-specific factors may have influenced the bond yield differentials in recent years.

Much of the decline over the past 25 years or so appears to be attributable to a fall in inflation expectations in the United Kingdom relative to inflation expectations in Germany and the United States. We find little evidence to suggest a convergence of real rates of interest or a secular decline in relative, country-specific risk premia. While much of the decline in the yield spreads can be attributed to changes in relative inflation expectations, we also believe that the dramatic decline in these spreads over the past three years cannot be entirely due to this. Instead, we believe that some of the recent decline is due to gilt market specific factors. Around one third of the decrease in UK-US and UK-German bond yield differentials observed since the beginning of 1997 has been, we suggest, related to a significant reduction in net gilt issuance combined with an increase in the demand for long-dated gilts from pension funds and life assurance companies. The evidence from long gilt yields does not appear to be consistent with EMU-convergence stories. Indeed, US forward rates are closer to euro rates in ten years' time than are UK forward rates.

Sterling wholesale markets: developments in 1999
(99k)
Sterling wholesale markets grew by £800 billion in 1999, though much of this reflected increased market values rather than new issuance Though the size of markets grew, liquidity in a number of core markets fell, reflecting both the retreat of risk capital following the global financial crisis of 1998 H2 and, in the gilt-edged market, reduced government borrowing and hence lower bond supply. The approach of the millennium date change also affected markets in 1999 H2, though liquidity and turnover in December turned out higher than many had expected. The Bank made two changes to its open market operations in 1999: a major permanent widening in the list of collateral eligible in OMOs; and, from October, the introduction of temporary three-month repos designed to help firms plan their liquidity over the year-end.

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.

Sterling market liquidity over the Y2K period
(17k)
The Bank of England has been making active preparations to promote orderly market conditions over the Y2K period. The successful testing of the key sterling market systems - CGO, CMO, CREST and RTGS - reported in the Bank's Blue Book series gives assurance to market participants that the infrastructure will operate normally. In parallel, the Bank has taken a number of steps to ensure that sterling market participants who have made proper preparations for Y2K can obtain adequate liquidity over the period to enable them to maintain normal business activity.

This statement summarises the arrangements that will operate over the period.

News and the sterling markets (83k)
(by Martin Brooke, Graeme Danton and Richhild Moessner of the Bank's Gilt-edged and Money Markets Division). The Quarterly Bulletin reports developments in financial markets in detail each quarter in the regular 'Markets and operations' article. Day by day, items of news about the economy-in the form of data releases and news about policy-are the most significant market-moving events. This article looks over a longer time period than is usually possible in the 'Markets and operations' article to answer the following two questions:

• Which news items tend to move the sterling interest rate markets most?
• How do different parts of the sterling yield curve respond to news?

The prices of financial assets adjust continually in response to news. This news can either be 'regular' (ie announcements that are released at pre-determined times known to market participants) or 'irregular' (ie events which are largely, or wholly, unexpected). This article examines how different parts of the sterling yield curve react to different types of regular news. We consider daily interest rate changes for three different assets: the nearest-maturity three-month interest rate futures contract traded on the London International Financial Futures and Options Exchange (LIFFE) (a contract based on three-month sterling Libor), the same LIFFE futures contract for a three-month interbank rate 2 years ahead, and the yield on the benchmark ten-year gilt.

According to the expectations theory of the term structure, forward interest rates are determined by expectations of the future path of short-term spot interest rates. In other words, longer-maturity interest rates embody expectations of future short rates at all dates up to the maturity of the loan. To the extent that this theory holds, the front (ie nearest-maturity) short sterling futures contract indicates the market's expectation for the level of three-month interest rates at the maturity of the contract. Similarly, the longer-dated futures contract used in our analysis provides information about the market's expectation for the level of three-month interest rates in 2 years' time. And the yield on the ten-year benchmark gilt should reflect average interest rate expectations over the life of the gilt (ie ten years). Changes in the prices of these three assets indicate how the term structure of sterling interest rates responds to news announcements.

The article concludes that the very short end of the sterling yield curve—as measured by the nearest short sterling contract—tends to change more on data and policy news days than on days when there is no significant news. That is also true, though to a lesser extent, for the short sterling contract two to three years ahead. Movements at the longer end of the yield curve—measured here by the change in the ten-year gilt yield—tend to be less closely tied to domestic news. Among individual domestic data releases, average earnings, RPIX and retail sales are the most significant market-moving events. Two key US data releases, consumer prices and non-farm payrolls, significantly affected the longer end of the UK yield curve.

Structural changes in exchange-traded markets
(33k)
(by Claire Williamson of the Bank's Market Infrastructure Division). This article outlines the main recent structural changes in exchange-traded markets-mergers between equity and derivatives exchanges, new international links between exchanges, and changes in exchanges' ownership structure. It analyses the factors that have prompted these developments, and reviews the implications that the changes may have for market-users, other types of infrastructure and the authorities.

The structure of exchange-traded markets continues to change. Three distinctive - and linked - trends are: mergers between equity and derivative exchanges within countries, new types of links between exchanges in different countries, and demutualisation. Links between exchanges are not new, and exchanges have been undertaking cross-listing links for a number of years. For example, the Chicago Mercantile Exchange (CME) and the Singapore International Financial Futures Exchange (SIMEX) have linked to cross-list the CME's eurodollar contract since 1984. What makes the current trends particularly significant is the nature of the economic forces driving change, particularly those arising from technological development, and the implications for market-users, other types of infrastructure and the authorities. The Bank's interest in this arises from its purpose of maintaining the stability of the financial system, and the effectiveness of UK financial services.

The current changes in market structure are comparable in scope to the changes that have happened to regional equity markets within countries. These regional markets gradually consolidated as communications improved, leaving most business being done in one national exchange in most countries. For example, the UK regional stock exchanges consolidated as long ago as 1973. This article describes three of the more recent trends in market structure and analyses the key factors driving these changes. It focuses on supply-side factors, though demand-side factors, such as changes in the demand for instruments resulting from EMU, are clearly also important.

The foreign exchange and over-the-counter derivatives markets in the United Kingdom (83k)
(by Jamie Thom of the Bank's Foreign Exchange Division and Jill Paterson and Louise Boustani of the Bank's Markets and Trading Systems Division). In April this year, the Bank of England conducted its regular survey of turnover in the United Kingdom foreign exchange and over-the-counter (OTC) derivatives markets, as part of the latest worldwide survey organised by the Bank for International Settlements (BIS). The foreign exchange market survey has been conducted triennially since 1986, and a parallel survey of the OTC derivatives markets was first conducted in 1995. The article sets out the results for the 1998 survey (in US$ billion), and compares them with the 1995 survey and results for other major centres.

The survey shows that:

• Average daily spot and forward foreign exchange turnover for April 1998 was $637 billion, 37% higher than the $464 billion per day recorded three years earlier (an annualised growth rate of 11%).
  
• Average daily turnover in the United Kingdom for OTC currency and interest rate derivatives was $171 billion, 131% higher than the $74 billion per day recorded three years earlier (an annualised growth rate of 32%).
  
• The United Kingdom has consolidated its position as the world's largest centre for foreign exchange and OTC derivatives business, accounting for 32% and 36% of the global foreign exchange and OTC derivatives markets respectively.
  
• The forward foreign exchange market continued to grow more rapidly than the spot market, which now represents only 35% of total foreign exchange turnover.
  
• US dollar/Deutsche Mark retained its position as the most widely traded currency pair (22% of all spot and forward foreign exchange transactions). The share of sterling trading rose, and sterling/US dollar regained its position as the second most actively traded currency pair (14% of turnover). Cross-trading of ERM currencies generally declined.
  
• The proportion of interest rate OTC derivatives turnover accounted for by swaps increased from 32% to 56%; the proportion accounted for by forward rate agreements (FRAs) fell from 59% to 35%.
  
• ERM currencies dominated the UK interest rate derivatives market, making up 56% of all trades. The Deutsche Mark almost doubled its share of the market, growing from 18% to 32%; all other major currencies lost market share.

Features of a successful contract: financial futures on LIFFE (47k)
(by Allison Holland and Anne Fremault Vila of the Bank's Markets and Trading Systems Division). The success of a futures contract, defined as its long-term survival, has generally been linked to the existence of a large and volatile spot market and to a design that makes the contract highly effective for hedging purposes. This article examines the importance of these and other factors, using data on the financial futures contracts introduced by LIFFE between 1982 and 1994.

The Bank of England's operations in the sterling money markets (19k)
On 3 March the Bank introduced reforms to its daily operations in the sterling money markets, through which it implements monetary policy. The changes relate to the mechanics of its day-to-day operations in the money markets; they do not alter its basic approach to implementing monetary policy, which remains to manage short-term interest rates through open market operations. This article describes the arrangements for the Bank's money-market operations, including those aspects which have not been changed.

Probability distributions of future asset prices implied by option prices (233k)
(by Bhupinder Bahra of the Bank's Monetary Instruments and Markets Division).
The most widely used measure of the market's views about the future value of an asset is the mean or average price expectation-a point estimate. This article shows how this information set can be extended by using option prices to estimate the market's entire probability distribution of a future asset price. It also illustrates the potential value of this type of information to the policy-maker in assessing monetary conditions, monetary credibility, the timing and effectiveness of monetary operations, and in identifying anomalous market prices. Finally, the article looks at the limitations in data availability and details some areas for future research.

Payment and settlement strategy (13k)
The Bank of England announced in November last year that it proposed to review, with market participants and other interested parties, the strategic requirements for payment and settlement for UK financial markets. The review was conducted during the first half of this year and this note summarises its findings. It was presented by the Governor to the City Promotion Panel on 3 July.

Bond yield changes in 1993 and 1994: an interpretation (46k)
(by Joe Ganley and Gilles Noblet of the Bank's Monetary Assessment and Strategy Division)
looks at a number of the explanations put forward for the turnaround in government bond markets, from their prolonged rally in 1993 to a protracted period of turbulence and reassessment for most of 1994. It presents the results of research exploring the role of monetary policy credibility in the yield changes over the two years.

Bond prices and market expectations of inflation (39k)
(by Francis Breedon)
describes the method-introduced last November-used for deriving from gilt prices the inflation expectations that appear regularly in the Inflation Report. It assesses how well the derived expectations would have predicted inflation in the past.

Risk measurement and capital requirements for banks (41k)
(by Patricia Jackson of the Regulatory Policy Division)
reviews developments in banks' use of statistically based tests to measure risks in both their traditional lending and borrowing, and their securities and derivatives trading, activities. It discusses how their increasing use is influencing the development of international capital standards.

Statistical information about derivatives markets (31k)
focuses on over-the-counter derivatives. It outlines the main accounting problems they raise, explains current initiatives to encourage firms to disclose information about their derivatives business and describes recent steps to improve the aggregate statistics available about OTC markets.