Box A: Declining Volatility in Global Asset
Markets
As derivative markets have become more liquid and the use of instruments such as options more
widespread, it has become increasingly possible to use information from these instruments to
analyse underlying asset markets. For example, pricing of options on equity, fixed-interest or
foreign exchange instruments contains information about the respective derivatives markets’
assessment of current conditions and expected future price movements in the underlying markets.
In this box we use the implied volatility of options1 to contrast fixed-interest and equity markets,
where implied volatility has declined noticeably, with foreign exchange markets where volatility
has not fallen as sharply.
Implied volatilities of the
major equity indices have declined
%
%
United States
Euro area
substantially since the start of 2003
55
55
(Graph A1). The high volatility
45
45
seen over 2002 reflected heightened
35
35
DAX 30
S&P 500
uncertainty about the global
25
25
15
15
economic outlook following the US
%
%
recession, corporate malfeasance,
Japan
Australia
55
55
Nikkei 225
the unwinding of the equity market
45
45
bubble and the war in Iraq. Volatility
35
35
ASX 200
moderated as major equity indices
25
25
15
15
began to rebound, corporate profits
5 l l l l l l l l l l l l l l l l l l l l l l l l l l 5
staged a strong recovery, and the
1995
2000
2005
1995
2000
2005
Sources: Bloomberg; RBA; SFE
general economic outlook improved.
The recent levels of implied
volatilities for the three major overseas equity markets are low, but not unprecedented. Implied
volatilities in the US and Europe have returned to levels that were typical between 1992 and
1996. Implied volatility in Japan, despite its recent fall, remains well above the lows reached in
1994. In contrast, the implied volatility of Australian equities is at an all-time low.
Graph A1
Implied Volatility of Equity Index Returns
Implied volatilities in fixed-interest markets have also declined significantly, with the volatilities
of shorter-term instruments falling by more than those of longer dated ones (Graph A2). Implied
volatilities gradually declined around the world in the second half of 2003, as it became clearer
1 The expected future volatility of the underlying asset is one of the most important determinants of the option price. There is
a higher chance that an option will provide a larger payoff when the future volatility of the underlying asset is higher, because
it is more likely that the price of the underlying asset will move more in favour of the option buyer while at the same time the
option buyer is not exposed to the adverse movements in the price. Therefore, option prices are higher when the expected future
volatility is higher. The implied volatility is the value of the volatility that equates the market price of an option to its theoretical
value. Implied volatility is higher when the option price and the expected volatility are higher. As a matter of convention, the
prices of options traded in over-the-counter markets are quoted in terms of the option implied volatility rather than in monetary
units.
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B A N K
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A U S T R A L I A
that the easing cycle was drawing
to a close, with some central banks
beginning to tighten monetary
policy after a prolonged period of
relatively low and stable interest
rates. It is possible that a large part
of the decline in implied volatilities
of interest rates can be attributed to
reduced uncertainty about the future
path of monetary policy at that
turning point.
Graph A2
Implied Volatility of Changes in Swap Rates
1-year options
Bps
United States
Bps
Euro area
160
160
120
120
80
80
40
40
Bps
Japan
Bps
Australia
160
160
120
120
10-year rate
80
80
There appears to be little evidence
40
40
1-year rate
that the compression of volatilities
l
l
l
l
l
l
l
l
l
l
l
l
l
l
l
l
0
0
1997
2001
2001
2005
2005
in equity and debt markets is being
Sources: Bloomberg; RBA
driven by an increased willingness
to supply (write) options. If options
writers were underpricing options in order to try to expand their activities, then implied volatility
would be persistently below the subsequently realised volatility of the underlying assets over the
life of the options. But recently, implied volatilities have generally moved in line with realised
volatilities across the major global asset markets.
In January 2002 the US dollar reached a multi-year high on a trade-weighted basis against the
major floating currencies. Since then, developments in implied volatilities of currencies against the
US dollar have been mixed. Some currencies, such as the Australian and Canadian dollars, have
seen increases in both short- and long-term implied volatilities. But for other currencies, such as
the euro and the yen, implied volatilities remain broadly unchanged (Graph A3). Overall, implied
volatilities of foreign exchange rates
Graph A3
have exhibited a less clear trend than
those observed in equity and fixedImplied Volatility of Currency Returns
against US Dollar
interest markets.
%
In general, recent developments
in option markets indicate an
expectation of continued low
volatility in equity and bond markets,
but continuing uncertainty in foreign
exchange markets. Despite these
developments, it is possible that the
recent low level of realised volatility
may have led markets to become a
little complacent and hence the low
implied volatility may not reflect
future risks in these markets. R
Euro
%
Yen
*
20
20
15
15
10
10
5
5
%
British pound
%
Australian dollar
20
1-month option
15
15
10
10
1-year option
5
0
20
l
l
l
l
1997
l
l
l
l
2001
l
l
l
l
l
2005
l
l
2001
5
l
l
l
0
2005
* Peak at 40%
Source: JPMorgan
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