Constructing a financial conditions index for the United Kingdom: A comparative analysis

Sheng Zhu, Ella Kavanagh and Niall O'Sullivan

International Journal of Finance & Economics, 2021, vol. 26, issue 2, 2976-2989

Abstract: We investigate the optimal constituent variable weighting method for a UK financial conditions index (FCI) using a small number of financial indicators. The criterion for choosing the optimal weighting model concentrates on the index's ability to predict economic activity. We develop a “two‐step” process as a new weighted‐sum method and show that it is superior to other existing weighted‐sum models in creating an FCI. For comparative purposes, we create another FCI using a time‐varying parameter factor‐augmented vector autoregressive (TVP‐FAVAR) with stochastic volatility model as a principal‐component method. The results suggest that the TVP‐FAVAR model is the best variable‐weighting model to create an FCI in relation to its purpose of forecasting developments in the economy.

Date: 2021
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