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Financial Fragility Indicator

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18 views2 pages

Financial Fragility Indicator

Uploaded by

abdulmaliknabeelmullah
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Financial fragility indicator

The financial fragility indicator is information condensed from financial variables to estimate the
probability whether or not if the financial system is under stress. The past two episodes that happened
in the US that can be called financial crises. The two episodes are the weeks surrounding the Russian
default and the recapitalization of Long-Term Capital Management in the fall of 1998 and the aftermath
of September 11, 2001. Even though they have different causes, many key financial variables acted in
very similar ways. The financial variables were risk, liquidity, term spreads, and implied volatilities. The
financial variables all became higher at rapid pace at the times of the crises. There are two steps in
constructing an indicator. The first step is to reduce the twelve individual variables listed in the panel to
three summary statistics. The three summary statistics evaluates their level, rate of change, and
correlation. The second step is to form a logit model and it is used to probability of the financial market’s
behavior being parallel to that of the two crises mentioned above.

[Exhibit 2 about here]

The three statistics used are Index of normalized variables, the rolling eight-week changes, and
comovement indicator. Index of normalized variables is the arithmetic average of the values of the
individual indicators, and it is normalized by their standard deviations from 1994 the present. During
acute stress the index is elevated. Financial markets are considered to be fragile when risk spreads,
liquidity premiums, and volatility indicators are moving higher. When the indicators decline sharply it can
be a sign that acute financial distress is coming to an end. The comovement indicator measures the
percentage of the total variation of the individual variables that can be explained by a common factor.

The three summary statistics are combined into one measure of financial fragility and is used to model
the probability that the financial system is in a scenario that is similar to the two episodes or crises. This
is accomplished by using a logit model with the three statistics as explanatory variables and a binary
variable that identify the crises.

is used for level indicator. is used for rate of change indicator.

is used for the comovement indicator


Mortgage market indicators

The total value of mortgages outstanding exceeded $10 trillion At the end of 2004, $8 trillion were
single-family residential mortgages. From the $8 trillion 4.5 trillion got pooled into mortgage-backed
securities. The Treasury market, the nonfinancial corporate bond market, and the agency market are all
smaller than MBS. Mortgages pooled into U.S. MBS can be prepaid with no penalty. This prepayment
option makes something know as Negative convexity. The duration decreases when yields decrease and
increases when yields increase in Negative convexity. Because of the size of the market, MBS investors
who desire to hedge the prepayment risk have to buy or sell large amounts of financial instruments.
Dynamic hedging example, because there is decline in the market interest rate an increase in
prepayment risk that reduces the duration of MBS outstanding. Because of this, holders who wish to
maintain the duration of their portfolios have to purchase other longer-term fixed-income securities to
add duration. mortgage-related hedging has the ability to make interest rates go above or below the
justified level of macroeconomic conditions, and it has the ability to increase the volatility of fixed-
income markets.

The impact that mortgage market conditions have on long-term interest rates is monitored by several
indicators. Times of when the duration increases or decreases rapidly can be associated with large
hedging flows.

[Exhibit 3 about here]

MBS convexity is the amount by which duration would change following a 100 basis points
change in yields). it depends on the likelihood that mortgage holders prepay their mortgages.
The likelihood is the distance between the current mortgage rate and the rate if outstanding
mortgages. Outstanding mortgages are economically refinanceable at a given mortgage rate.
The higher or more negative the convexity of the MBS market is the steeper the cumulative
distribution is. In the middle of 2005, convexity was at peak negativity. This suggests that the
potential risk of increased volatility was high.

MBS duration and convexity are used to estimate how much long term interest rates shocks are going to
be amplified by mortgage-related hedging flows. the amplification factors happen by placing GARCH
model to the volatility of interest rates, for this to the hedging flows have to be determined by either the
duration, convexity ,or the market’s refinancing activity amount. Hedging activities are not the factor
that sets of move in interest rate, but they amplify the moves already placed.

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