However, interest rate derivatives have experienced stronger growth given the sensitivity to interest rate changes and the need to manage exposure to fixed and floating rate financial assets. BIS Review 11/2004  1  In the international financial markets, the growth in OTC derivatives has been phenomenal in recent years. The statistics compiled by the Bank for International Settlements indicate that as of the end of June 2003 the total outstanding OTC derivatives in notional amounts was 169 trillion US dollars. This total figure includes 22 trillion US dollars of foreign exchange contracts, 121 trillion US dollars of interest rate contracts, principally swaps, 2.7 trillion US dollars of equity-linked contracts, almost 1 trillion US dollars of commodity contracts and 18 trillion US dollars classified as Others. The fact that growth in financial derivatives has far surpassed the growth in the underlying real economies that generated the original transactions and risks for diversification is a matter of concern to regulators. It seems that speculators appear to have embraced derivatives as another form of investment for short-term capital gains. If financial derivatives take on a life of their own due to excessive speculative activity, the utility for risk diversification may prove illusory from a systemic point of view because the new risks introduced by derivatives may well overshadow the risks posed to the financial system by the underlying more risky financial assets.
Thus, it is useful to complement this measure with expectations extracted from inflation derivatives. In particular, inflation-linked swap rates provide a measure of the expected inflation rates at short horizons (one and two years ahead, for example). 8 One-year inflation swap rates fell sharply in the second half of 2008 (slide 13), following the decline in oil prices and the worsened macroeconomic outlook, and remained between 0.0% and 0.5% until recently. However, they have returned to levels above 1% since early April 2009. The chart also displays market uncertainty about the future inflation outcomes in the euro area, represented by the coloured areas. Unsurprisingly, uncertainty has increased since October 2008. Furthermore, in line with developments in point expectations, the probability associated with negative inflation readings within a 12-month horizon increased in the months following October 2008, as indicated by the shaded areas below the zero line, but has declined somewhat in recent months. The evolution of the term structure of inflation expectations suggests a similar pattern of gradual adjustment at slightly longer horizons (slide 14). Two-year-ahead inflation expectations have moved in tandem with shorter inflation expectations. Yet, the fact that they have never become negative, and that they are now back at levels ‘close to, but below, 2%’ – which is the ECB’s definition of price stability – offers further ‘comfort’ for monetary policy. It should be kept in mind that the liquidity of shorter-term inflation swaps is somewhat inferior to longer-horizon contracts, and the readings should thus be interpreted with appropriate care.