CISS — A Portfolio-Theoretic Framework for the Construction of Composite Financial Stress Indices

Abstract

This paper introduces a novel indicator of current stress in the …nancial system as a whole named Composite Indicator of Systemic Stress (CISS). Its speci…c statistical design is shaped in accordance with standard de…nitions of systemic risk. The main innovative feature of the CISS is the application of portfolio theory to the aggregation of individual stress indicators into the composite index. Along the lines of how portfolio risk is computed from the risks of individual assets, we propose to compute the level of stress in the system as a whole by aggregating …ve market-speci…c subindices of stress - comprising a total of 15 individual stress indicators - on the basis of a time-varying measure of the cross-correlations � We thank Philipp Hartmann for inspiring and supporting this project throughout all stages. Philipp also invented the indicator’s name and its abbreviation CISS (pronounced like “kiss”). We thank Tommy Kostka for outstanding research assistance and for several good ideas which helped improving the CISS. Very helpful comments from Geert Bekaert, Hans Degreyse, Wolfgang Lemke, Simone Manganelli, Seth Pruitt and an anonymous referee are gratefully acknowledged. We …nally thank seminar participants at the Euro Area Business Cycle Network conference “Econometric Modelling of Macro-Financial Linkages”in Florence, the 5th CSDA International Conference on Computational and Financial Econometrics in London, the Board of Governors of the Federal Reserve System, the Sveriges Riksbank, the AEA 2013 Annual Meeting in San Diego and the joint Federal Reserve Bank of Cleveland and O¢ ce of Financial Research conference “Financial Stability Analysis: Using the Tools, Finding the Data”for fruitful discussions and comments. However, the views expressed in this paper are those of the authors and do not necessarily re‡ect those of the European Central Bank, the Eurosystem or the Magyar Nemzeti Bank.