Financial markets
Financial instruments such as stocks, bonds and foreign exchange are traded in financial markets. While the primary purpose of financial markets is to facilitate the exchange of funds from lenders to borrowers, some markets—such as those for derivatives—allow for risk management.
The well-functioning of financial markets is critical for financial stability. Financial markets enable risk to be transferred across the financial system, which allows assets to be priced efficiently. It is also mainly through financial markets that the Bank of Canada’s key policy rate influences interest rates and exchange rates. This, in turn, helps the Bank achieve its monetary policy objectives. Markets that function well also allow governments and businesses to secure funding when needed, with less uncertainty.
The Bank closely monitors financial markets and assesses risks to their stability, notably with respect to liquidity in key markets that businesses and governments rely on to finance their activities. In particular, the Bank monitors markets for Government of Canada bonds, provincial bonds and corporate bonds.
Market liquidity
In periods of stress, financial market participants may face greater demand for cash. For example, fund managers may need to pay investors who wish to withdraw their funds and agents using leverage may face margin calls. To generate cash, these agents may want to sell their existing holdings. The ability to sell securities quickly, at a predictable price, is referred to as market liquidity. The Bank of Canada uses several indicators to monitor market liquidity:
- The bid-ask spread of Government of Canada (GoC) bonds and provincial bonds measures the difference between the cost of buying a bond and the return earned from selling that same bond. When the bid-ask spread is small, financial market participants know that they can buy and sell the same bond without incurring large costs, signalling a highly liquid market. The Bank uses the Roll (1984) bid-ask spread proxy to measure this cost.
- The price impact of GoC and provincial bonds measures how much the price of a security moves when a participant buys or sells bonds. When the price impact is low, participants can sell a large quantity of the security, and the price will remain relatively stable. A low price impact indicates that the market is highly liquid because agents can sell a larger quantity of the security without the price falling by too much. The Bank uses the Amihud (2002) price-impact proxy to measure this cost.
- The liquidity of the Canadian corporate bond market is a proxy based on the difference between price and net-asset value of exchange-traded funds that primarily hold Canadian corporate bonds (Arora et al. 2019). Compared with GoC and provincial bonds, corporate bonds trade relatively infrequently, which makes it difficult to use the bid-ask spread and price impact measure to assess the liquidity of the corporate bond market.
- The realized yield volatility of GoC bonds measures the fluctuation of prices for GoC bonds over a specific period. When economic conditions are uncertain, the prices of securities may change more frequently as market participants try to predict the future value of securities. How much the value of a security changes over time is referred to as its volatility. When a security has low volatility, participants—notably investment dealers who trade with clients and then seek to quickly offset their risk—are relatively certain of how much they could get by selling it in the future, which is a sign of a highly liquid market.
For more information, see the notes.
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