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Financial Risk Indicator: A New Tool for Measuring Market Volatility

A team of economists from the European Central Bank, International Monetary Fund, and Arcturis Data has developed a new financial risk indicator that can help predict market volatility and identify potential risks in the Chinese economy.

Methodology

Using machine learning algorithms to analyze a large dataset of newspaper articles reporting on financial risk in China since 2005, the researchers created an unsupervised model that endogenously extracts individual financial risk components while assessing their weight and impact on the overall indicator. The result is a robust measure of financial risk that correlates with other indicators used for the Chinese economy.

Alternative Indicators

The research team constructed three alternative financial risk indicators using different approaches, including:

  • Principal Component Analysis (PCA)
  • Regression analysis

While the PCA-based indicator showed less significant responses compared to shocks to the core index, the regression- based indicators produced similar Impulse Response Functions (IRFs) as the core index, although with smaller magnitude.

Key Findings

  • The financial risk indicator correlates with other indicators used for the Chinese economy.
  • The indicator captures financial risk episodes in China and does so in a timely fashion.
  • Regression-based indicators produce similar IRFs as the core index, although with smaller magnitude.
  • PCA-based indicator shows less significant responses compared to shocks to the core index.

Authors

  • Alexander Al-Haschimi, Team Lead Economist at the European Central Bank
  • Apostolos Apostolou, Economist at the International Monetary Fund
  • Andres Azqueta-Gavaldon, Machine Learning Researcher at Arcturis Data
  • Martino Ricci, Senior Economist at the European Central Bank

Source

Authors’ Calculations. Notes: IRFs report percentage changes for all variables excluding EMBI Global spreads and the 7-day repo rate which are reported in bps. Dotted lines report the 68% credibility interval.

About SUERF

The Society for Universal Economic Research (SUERF) is a network association of central bankers, regulators, academics, and practitioners in the financial sector. Its focus is on analyzing, discussing, and understanding financial markets and institutions, monetary policy, and regulation.