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Predicting Covariance Matrices with Financial Conditions Indexes

Anne Opschoor, Dick van Dijk () and Michel van der Wel ()
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Anne Opschoor: Erasmus University Rotterdam

No 13-113/III, Tinbergen Institute Discussion Papers from Tinbergen Institute

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.

Keywords: Dynamic correlations; Volatility modeling; Financial Conditions Indexes; Bank holding companies (search for similar items in EconPapers)
JEL-codes: G17 G23 E44 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban and nep-mac
Date: 2013-08-09
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