Financial markets

  • December 16, 2000

    The Bank of Canada's Management of Foreign Currency Reserves

    This article describes the Bank's management of the liquid foreign currency portion of the government's official reserves. It broadly outlines the operations of the Exchange Fund Account (EFA), the main account in which Canada's reserves are held. It then briefly reviews the evolution of the objectives and management of the EFA over the past 25 years, particularly in light of the changing level of reserves and developments in financial markets. The EFA is funded by Canada's foreign currency borrowings in capital markets. The article focuses on the comprehensive portfolio framework used to manage the Account, which matches assets and liabilities. Under this framework, funds are invested in assets that match, as closely as possible, the characteristics of foreign currency liabilities issued, helping to immunize the portfolio against currency and interest rate risks.
  • November 16, 2000

    Credit Derivatives

    Credit derivatives are a useful tool for lenders who want to reduce their exposure to a particular borrower but are unwilling to sell their claims on that borrower. Without actually transferring ownership of the underlying assets, these contracts transfer risk from one counterparty to another. Commercial banks are the major participants in this growing market, using these transactions to diversify their portfolios of loans and other risky assets. The authors examine the size and workings of this relatively new market and discuss the potential of these transactions for distorting existing incentives for risk management and risk monitoring.
  • Steps in Applying Extreme Value Theory to Finance: A Review

    Staff Working Paper 2000-20 Younes Bensalah
    Extreme value theory (EVT) has been applied in fields such as hydrology and insurance. It is a tool used to consider probabilities associated with extreme and thus rare events. EVT is useful in modelling the impact of crashes or situations of extreme stress on investor portfolios.
    Content Type(s): Staff Research, Staff Working Papers Topic(s): Financial markets JEL Code(s): C, C0, C4, C5, G, G1
  • August 14, 2000

    Approaches to Current Stock Market Valuations

    The increase in North American stock prices in 1999 and early 2000 has generated interest in the valuation assumptions that would make these price levels sustainable. Here, commonly used valuation techniques are applied to stock markets in Canada and the United States. For the comparative yield approach, real interest rates (rather than nominal rates) are preferred as the comparator of choice to yields on stock market indexes. The spreads between real interest rates and stock market yields have generally increased over the last two years. The dividend-discount model (DDM) approach provides an analytic linkage between the equity-risk premium and the expected growth of dividends. It suggests that market values (measured at the end of February 2000) could be sustained only by rapid growth of dividends in the future or by the continued assumption of an uncharacteristically low risk premium on equity. The spectacular rise in the value of technology stocks in 1999 is noted (Chart 4), and then the valuation measures for the Canadian stock market excluding the technology sector are examined. When this is done with the comparative yield approach, yield spreads are slightly lower, and for the DDM approach, one does not need to assume as high a growth of dividends or as low a risk premium to validate market valuations. Two effects of the "new economy" on the stock market are noted. One is the lowering of dividend yields, as new-economy technology companies tend to have a high reinvestment rate and a low dividend payout rate. Another relates to the potential for a higher track for the economy's productivity growth, which would mean that higher-than-historical assumptions about future earnings growth would be more plausible. Several explanations for the decline in risk premiums on equity are considered. While short-term volatility in the stock market has, if anything, increased in recent years, low inflation and improved economic performance, along with demographics and investor preferences, may have contributed to a decline in the risk premium demanded by investors. A scenario of rapid growth of dividends in the near term slowing to historical norms in the longer term is examined. While this approach can go partway towards explaining high stock market valuations, it requires assumptions that are outside historical experience.
  • Modelling Risk Premiums in Equity and Foreign Exchange Markets

    Staff Working Paper 2000-9 René Garcia, Maral Kichian
    The observed predictability of excess returns in equity and foreign exchange markets has largely been attributed to the presence of time-varying risk premiums in these markets. For example, excess equity returns were found to be explained by various financial and economic variables.