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Predicting Covariance Matrices with Financial Conditions Indexes

Author

Listed:
  • Anne Opschoor

    (Erasmus University Rotterdam)

  • Dick van Dijk

    (Erasmus University Rotterdam)

  • Michel van der Wel

    (Erasmus University Rotterdam)

Abstract

This discussion paper resulted in a publication in the 'Journal of Empirical Finance' (2014). Volume 29, pages 435-447. We model the impact of financial conditions on asset market volatility and correlation. We propose extensions of (factor-)GARCH models for volatility and DCC models for correlation that allow for including indexes that measure financial conditions. In our empirical application we consider daily stock returns of US deposit banks during the period 1994-2011, and proxy financial conditions by the Bloomberg Financial Conditions Index (FCI) which comprises the money, bond, and equity markets. We find that worse financial conditions are associated with both higher volatility and higher average correlations between stock returns. Especially during crises the additional impact of the FCI indicator is considerable, with an increase in correlations by 0.15. Moreover, including the FCI in volatility and correlation modeling improves Value-at-Risk forecasts, particularly at short horizons.

Suggested Citation

  • Anne Opschoor & Dick van Dijk & Michel van der Wel, 2013. "Predicting Covariance Matrices with Financial Conditions Indexes," Tinbergen Institute Discussion Papers 13-113/III, Tinbergen Institute.
  • Handle: RePEc:tin:wpaper:20130113
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    File URL: http://papers.tinbergen.nl/13113.pdf
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    Keywords

    Dynamic correlations; Volatility modeling; Financial Conditions Indexes; Bank holding companies;

    JEL classification:

    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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