Weighting Methods for Financial Stress Indices - Comparison and Implications for Risk Management

Abstract

Financial stress indices (FSIs) involve the weighting and compilation of different sub-indices and indicators into an overall measure of systemic stress. Despite the importance of weighting with regard to the relevance of single indices or indicators (structural effect), the behavior of the overall index over time (dynamic effect) and further consequences from applications of the FSI, the effects of weighting have rarely been investigated in a systematic way. Therefore, this study focuses on the effects that different weighting methods have on the construction and interpretation of FSIs. Six weighting approaches are compared on a conceptual and empirical basis. Based on the aggregation of time series for different sub-indices and indicators from 1991 to 2011, it is shown that weighting impacts the composition and the behavior of an FSI. Strategies for risk management and supervision based on FSIs have to take these effects into account and choose weighting methods accordingly.

Keywords: Financial stress index, Weighting, Market transparency, Systemic risk, Risk alerts

JEL Classification: C50, E50, G01, G10