2  BIS Review 2/2003  markets enhance the ability to manage and trade risk, they are at the heart of modern finance and the backbone of financial innovation. Their development has enabled market participants to hedge risk, develop arbitrage, and, therefore, enhance the efficiency of price setting in financial markets. Of course, the other side of the coin is that derivatives are sometimes criticised as they may be regarded under some circumstances as a potential threat to financial stability. I will come back to this point later on. The elimination of currency risk within the euro area has also had far-reaching effects on the equity markets. This is crystal clear when observing volatility patterns and portfolio allocation methods. As regards volatility patterns, recent developments seem consistent with the predictions of economic theory, where stock prices should reflect expectations of future dividends, interest rates and risk premia. It follows that the introduction of the euro should be associated with a reduction in differences 7 in volatility across markets. Indeed, a recent empirical study demonstrates that those countries whose stock exchanges had a structural high or medium volatility regime, converged towards those with a low volatility regime. From the point of view of the European stock market as a whole, this shows an improvement in global efficiency. As regards investment patterns, sector-diversification strategies have been defined as an alternative to country diversification.
Before EMU, it was common practice for institutional investors to make geographical diversification their first priority, and, secondly, to select securities in accordance with a sectoral diversification pattern. There is some evidence that the “home bias” has weakened since the introduction of the euro. For instance, assets held by pan-European investment funds represented 8 25% of total assets at the end of 2000, up from 12% in 1998. The development of a genuine panEuropean approach is also illustrated by the introduction of various European stock indexes. The turnover on options based on these indexes - for instance, the volume of options traded on the Eurostoxx50 contract - now matches the turnover of options based on well-established domestic indexes such as the CAC in France. This provides evidence that large investors are looking for - and actually have recourse to - hedging products that are suited to a cross-border oriented strategy. However, this evidence of a strong impetus towards integration does not necessarily support the argument that a brand new asset allocation is overwhelmingly dominant. Let me emphasise two aspects. First, pan-European sectoral strategies have also embraced non-euro area stocks in order to reach an appropriate level of diversification. This is the case in sectors such as pharmaceuticals, or telecom equipment, with stocks listed in non-euro area countries such as Switzerland, the United Kingdom and Sweden. This is in line with some theoretical assumptions, which are stating that currency risk is outweighed by the risk-return parameters, as far as investing in equities is concerned.