The Impact of the Financial Stress Indicator on the Currency and Stock Markets

Today we will talk about the impact of the financial stress index on the rates of currency pairs with the US dollar, gold and the US stock market.

Analysts, bankers and politicians use many indicators to track the conditions of financial markets.

A stress index has been developed to help the public to monitor the financial markets conditions.

The index is based on 18 data series, which are the averages of the daily data series for the week. The index consists of 6 yield spreads, 7 interest rates and 5 additional indicators that reflect different stress aspects in financial markets.

The authors K. Klisen and M. McCracken propose to interpret the index as follows:

The initial value of the index was calculated at the end of 1993 and was equal to zero. In the following, zero is considered as the value of the normal functioning of financial markets. Values below zero suggest below-average financial market stress, while values above zero suggest above-average financial market stress.

Analysis of the obtained results

The presence or absence of a relationship between changes in the financial stress index and quotations of financial instruments will be determined using the week-to-week correlation coefficient and with shifts of 1, 2, 3 and 4 weeks forward and backward. When determining the strength of the relationship, we will focus on the Chaddock scale:

The results are presented in the diagrams:

So, there is a weak week-to-week direct link between changes in the financial stress index and the USDRUB rate.

A weak week-to-week reverse connection has been identified between changes in the financial stress index, the USDJPY currency pair and the S&P 500 index.

There is no relationship between changes in the financial stress index, gold and the following currency pairs rates: AUDUSD, EURUSD, GBPUSD, NZDUSD, USDCAD, USDCHF.

The financial stress index and the considered financial instruments do not follow each other, since the correlation coefficient at shifts does not reach the value of 0.1 modulo.

Now let's evaluate the rate of return of the trade opening strategy based on the financial stress index:

• If the financial stress index is positive, we sell gold, the S&P 500 index and pairs with the quoted currency USD, we buy pairs with the base currency USD.
• If the financial stress index is negative, we buy gold, the S&P 500 index and pairs with the quoted currency USD, we sell pairs with the base currency USD.

Market entry strategy:

We enter the market at the Monday opening after the Friday data update, if the value of the financial stress index modulo is greater than the established threshold (p).

Exiting the market:

• at the close of the current week;
• at the close of the second week;
• at the close of the third week;
• at the close of the fourth week;
• at the close of Friday when the opposite signal appears.

Values of the p parameter:

• (-1.5) - (-1) (medium relaxation),
• (-1) - (-0.5) (low relaxation),
• (-0.5) - 0 - 0.5 (normal conditions)
• 0.5 - 1 (low stress)
• 1 - 1.5 (medium stress),
• от 1.5 (high stress).

Theoretically, the greater the modulo value of the financial stress index, the stronger the expected reaction of financial instruments.

The strategy will be evaluated according to the following criteria:

• The average rate of return reflects the relative change in quotes of financial instruments in percentage. A positive value of the average return indicates the profitability of the strategy, a negative one indicates a loss.

The average rate of return (R) of a financial instrument is given by the formula:

where:

n - the number of transactions;

P (%) – the percentage of change in the quotation of the financial instrument at the time of fixing the position, is calculated as follows:

for buy positions

P (%) = (position closing price - position opening price) / position opening price * 100%

for sell positions

P (%) = (position opening price - position closing price) / position opening price * 100%

• Maximum rate of return (MaxR) is the maximum profit from closing successful transactions for the entire trading period, as a percentage. The higher the maximum rate of return value, the better the trading signal works.

MaxR = max (R)

• Max drawdown (MD) is the maximum of losses when closing unsuccessful transactions for the entire trading period, in percent (minimum profitability). The lower the value of the maximum drawdown, the better the trading signal works.

MD = | min (R) |

• Share of profitable positions (SPP) shows the share of profitable trading positions from the total number of positions, as a percentage. The higher the DPP, the more profitable trades are made.

SPP = number of profitable positions / total number of positions * 100

The results of the strategy for exiting the market 1,2,3,4 weeks after entry are presented in the diagrams:

So, currency pairs have shown a significant rate of return under high stress in the financial market, with the closing of positions after 3 and 4 weeks.

The maximum rate of return is 0.4% when entering the market under high stress and exiting the market 4 weeks after entry. The number of transactions in this case is 70, and the share of profitable positions is 52%.

That is, under high stress conditions, currency pairs with the base currency USD mainly grow, and pairs with the quoted currency USD decrease.

Gold has demonstrated a significant negative rate of return under medium stress/relaxation and under high stress with holding positions for 2, 3 and 4 weeks.

The minimal rate of return is -1.4% when entering the market under high stress and exiting the market 4 weeks after entry. The number of transactions in this case is also equal to 70, and the share of profitable positions is 40%.

This means that gold grows during periods of medium to high stress. It decreases during periods of medium relaxation.

It should also be noted that as the threshold value of the financial stress index grows, the maximum rate of return of currency pairs and gold remains practically unchanged, while the maximum drawdown decreases, thereby reducing the spread of profits and losses.

The rate of return of the S&P 500 index does not reach a significant value at any level of stress/relaxation.

The results of the strategy with an exit from the market by the opposite signal are presented in the diagrams:

So, the strategy of entering the market without filtering (p = 0) has shown a rate of return:

• 0.4% for currency pairs;
• 3.6% for gold;
• 1.4% for S&P 500 Index.

That is, making entries into the market according to the strategy and exiting the market when the opposite signal appears, the above rate of return can be expected.

Trading under conditions of low, medium and high stress/relaxation (p = 0.5), excluding normal market conditions, with an exit from the market by the opposite signal, has led to a decrease in the instruments’ rate of return:

• 0.1% for currency pairs;
• -0,8% for gold;
• 0,8% for S&P 500 Index.

A similar trend has been revealed when filtering market entries with a stress index of 1 and 1.5 modulo. The following instruments’ rate of return has been shown:

р = 1:

• -0,9% for currency pairs;
• -5,1% for gold;
• -0,8% for S&P 500 Index.

р = 1,5

• -1,1% for currency pairs;
• -4% for gold;
• -5,2% for S&P 500 Index.

That is, under conditions of medium and high stress/relaxation, it is better to act with the help of “vice versa” entries according to the strategy signals in anticipation of the opposite signal.

At the same time, it should be taken into account that in anticipation of the opposite signal, the position had been kept opened from a week to 3 years and 10 months. The average position holding period was 8 months.

Note also that as the threshold value of the financial stress index grows, the maximum rate of return and drawdown decrease, thereby reducing the spread of profits and losses.

Detailed results are shown in the Appendix:

XLSX (0.20 MB)The impact of the financial stress indicator on the currency and stock markets.xlsx