A new financial stress indicator: properties and conditional asset price behavior

Abstract

The main goal of this paper is to introduce a new financial stress indicator, signaling regime transitions from stability to turbulence. This indicator is based on the combination of a wide range of market prices of risk, properly normalized to make them comparable across markets and time periods. After describing the construction and basic properties of the indicator, we discuss the conditional behavior of a basket of liquid assets. When the risk aversion signal breaches certain thresholds, risky assets dramatically correlate and their risk rewards deteriorate. Sharpe ratios decrease and drawdowns increase. Also, at the onset of chaotic phases, standard risk metrics fail to give an adequate representation of potential losses. These findings have significant implications for asset allocation and risk management purposes.

Keywords: Financial stress indicators, risk premiums, tactical asset allocation, risk measures, systemic risk

JEL Classification: G11, G28, C58, G01