Constructing A Financial Conditions Index for the United Kingdom: A Comparative Analysis

Sheng Zhu, Ella Kavanagh, Niall O'Sullivan, (2020). Constructing A Financial Conditions Index for the United Kingdom: A Comparative Analysis, International Journal of Finance and Economics, Forthcoming

37 Pages Posted: 13 Jul 2020

See all articles by Sheng Zhu

Sheng Zhu

Willis Towers Watson - The Asset Management Exchange

Ella Kavanagh

affiliation not provided to SSRN

Niall O'Sullivan

University College Cork

Date Written: June 18, 2020

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.

Keywords: Financial Conditions Index, TVP-FAVAR

JEL Classification: C11, C53, E44, E52

Suggested Citation

Zhu, Sheng and Kavanagh, Ella and O'Sullivan, Niall, Constructing A Financial Conditions Index for the United Kingdom: A Comparative Analysis (June 18, 2020). Sheng Zhu, Ella Kavanagh, Niall O'Sullivan, (2020). Constructing A Financial Conditions Index for the United Kingdom: A Comparative Analysis, International Journal of Finance and Economics, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3630903 or http://dx.doi.org/10.2139/ssrn.3630903

Sheng Zhu (Contact Author)

Willis Towers Watson - The Asset Management Exchange ( email )

2nd Floor
85 South Mall
Cork, Munster T12 A3XN
Ireland

Ella Kavanagh

affiliation not provided to SSRN

Niall O'Sullivan

University College Cork ( email )

Department of Economics
University College Cork
Cork, n/a
Ireland

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