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Forecasting Financial Market Vulnerability in the U.S.: A Factor Model Approach

Listed author(s):
  • Hyeongwoo Kim
  • Wen Shi

This paper presents a factor-based forecasting model for the financial market vulnerability in the U.S. We estimate latent common factors via the method of the principal components from 170 monthly frequency macroeconomic data to out-of-sample forecast the Cleveland Financial Stress Index. Our factor models outperform both the random walk and the autoregressive benchmark models in out-of-sample predictability for short-term forecast horizons, which is a desirable feature since financial crises often come to a surprise realization. Interestingly, the first common factor, which plays a key role in predicting the financial vulnerability index, seems to be more closely related with real activity variables rather than nominal variables. The recursive and the rolling window approaches with a 50% split point perform similarly well.

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File URL: http://cla.auburn.edu/econwp/Archives/2015/2015-04.pdf
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Paper provided by Department of Economics, Auburn University in its series Auburn Economics Working Paper Series with number auwp2015-04.

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Date of creation: Apr 2015
Handle: RePEc:abn:wpaper:auwp2015-04
Contact details of provider: Postal:
0326 Haley Center, Auburn University, AL 36849-5049

Phone: (334) 844-4910
Fax: (334) 844-4615
Web page: http://cla.auburn.edu/economics/

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  1. El-Shagi, M. & Knedlik, T. & von Schweinitz, G., 2013. "Predicting financial crises: The (statistical) significance of the signals approach," Journal of International Money and Finance, Elsevier, vol. 35(C), pages 76-103.
  2. Mikhail V. Oet & John M. Dooley & Stephen J. Ong, 2015. "The Financial Stress Index: Identification of Systemic Risk Conditions," Risks, MDPI, Open Access Journal, vol. 3(3), pages 1-25, September.
  3. Christensen, Ian & Li, Fuchun, 2014. "Predicting financial stress events: A signal extraction approach," Journal of Financial Stability, Elsevier, vol. 14(C), pages 54-65.
  4. Miguel Morales & Dairo Estrada, 2010. "A financial stability index for Colombia," Annals of Finance, Springer, vol. 6(4), pages 555-581, October.
  5. Cevik, Emrah Ismail & Dibooglu, Sel & Kenc, Turalay, 2013. "Measuring financial stress in Turkey," Journal of Policy Modeling, Elsevier, vol. 35(2), pages 370-383.
  6. Kevin L. Kliesen & Douglas C. Smith, 2010. "Measuring financial market stress," Economic Synopses, Federal Reserve Bank of St. Louis.
  7. Miroslav Misina & Greg Tkacz, 2009. "Credit, Asset Prices, and Financial Stress," International Journal of Central Banking, International Journal of Central Banking, vol. 5(4), pages 95-122, December.
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