Template-Type: ReDIF-Paper 1.0 Series: Tinbergen Institute Discussion Papers Creation-Date: 2013-08-09 Number: 13-113/III Author-Name: Anne Opschoor Author-Workplace-Name: Erasmus University Rotterdam Author-Name: Dick van Dijk Author-Workplace-Name: Erasmus University Rotterdam Author-Name: Michel van der Wel Author-Workplace-Name: Erasmus University Rotterdam Title: Predicting Covariance Matrices with Financial Conditions Indexes 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. Classification-JEL: G17, G23, E44 Keywords: Dynamic correlations, Volatility modeling, Financial Conditions Indexes, Bank holding companies File-Url: http://papers.tinbergen.nl/13113.pdf File-Format: application/pdf File-Size: 754948 bytes Handle: RePEc:tin:wpaper:20130113