In addition, expectations for increased investor demand for euro-denominated investments, together with the possibility of reduced participation by speculative and arbitrage trading accounts, are likely to have an effect on spreads of fixed-income securities to Treasuries. Traders in various fixed-income markets already have begun to note increased levels of spread volatility and expectations for higher absolute spreads relative to historical levels in response to these market dynamics. In this environment, managing market risk will become more difficult as the nature of fixedincome spread products changes. As we recently have learned, spread relationships that had endured for many years can break down suddenly, thereby increasing the already complex task of hedging positions. The increase in the liquidity premium for on-the-run Treasury securities last fall resulted in increased hedge-related activity in both the interest-rate swap and Treasury futures markets. Traders have continued to explore the usefulness of non-Treasury fixed-income securities as hedging vehicles. Risk managers must, therefore, be especially rigorous in analyzing their firms’ positions and hedging strategies, particularly when historical experience may not be as predictive a guide as it once seemed to be. I am encouraged by some recent market efforts to improve risk management practices. In lending, the risk-return discipline has been greatly enhanced at some international banks. These institutions have introduced measures to compare credit spreads with historical loss rates on well defined categories of credit. They also have enhanced the methods they use to assign internal risk ratings to individual credit exposures.

When economic agents also understand Norges Bank’s response pattern in connection with events in the economy, market expectations concerning the interest rate will change as a result of economic news and to a lesser extent as a result of Norges Bank’s interest rate decisions in themselves. Norges Bank reduced the key rate at the monetary policy meeting on 17 September 2003. Short-term interest rates showed little change since the interest rate decision was expected by market participants. At the same time, the Bank changed its bias concerning future inflation. At the monetary policy meeting in August, the Bank stated that, with an interest rate of 3 per cent, the probability that inflation two years ahead would be lower than 2½ per cent was greater than the probability that it would be higher. Following the meeting on 17 September, the Bank stated that, with an interest rate of 2.50 per cent, the probability that inflation two years ahead would be higher than 2½ per cent was the same as the probability that it would be lower. Expectations concerning future short-term interest rates rose slightly, probably as a result of the change in Norges Bank’s bias concerning future inflation. This was perceived as new information by market participants. The yield curve was therefore a little steeper following the monetary policy meeting. 4  6  Svensson, L.E.O. (September 2002), "Monetary Policy and Real Stabilization". Princeton University  BIS Review 46/2003  The market’s expectations concerning future short-term rates can be reflected in forward rates.