Impulse Response Functions and Causality Test of Financial Stress and Stock Market Risk Premiums

Vichet Sum

doi:10.5430/ijfr.v4n1p1

Abstract

Using the vector autoregressive (VAR) framework, this study empirically documents the impulse response functions of financial stress and market risk premiums and performs a causality test of these two variables. The analysis of the monthly changes of the Federal Reserve Bank of St. Louis Financial Stress Index and excess returns on the CRSP value-weighted index from 1994:2 to 2012:5 shows that market risk premiums become negative in the first, second and third, fourth and twelfth months following the financial stress shock. The degree of financial stress drops in the first, second, fourth, fifth, seventh, tenth months following risk premium shock. There is no observed feedback response from financial stress to market risk premium shock. The Granger causality test results show that financial stress Granger-causes market risk premiums to drop significantly, and there is no reverse causation recorded in this case. In addition, the time-series OLS regression analysis shows a statistically significant negative coefficient (b = -8.50; t = -9.20) when explanatory variable is the monthly changes in financial stress.

Highlights

The health of the financial sector can have significant direct and indirect effects on the real economy because this sector is responsible for saving mobilization and credit allocation across time and space
Little is known about the how stock market responds to financial stress shock. It is the problem of this study to empirically document how stock market risk premiums respond to financial stress and to test the causal link between financial stress and stock market risk premiums
Before performing the vector autoregression analysis, Schwarz's Bayesian information criterion (SBIC), the Akaike's information criterion (AIC), and the Hannan and Quinn information criterion (HQIC) tests are performed to determine the appropriate length of lags to be included in the model

Summary

Introduction

The health of the financial sector can have significant direct and indirect effects on the real economy because this sector is responsible for saving mobilization and credit allocation across time and space. The financial sector provides payment and fund transfer services which are vital to both businesses and consumers; households and businesses can use various financial products to maximize their utility and manage potential risks. Likewise, when the financial sector is healthy, credit should become more available and the cost of finance should be more affordable, on average. Businesses, consumers, and financial institutions are hesitant to invest, spend, and extend credit when the financial sector is stressful (Hakkio & Keeton, 2009); tightened credit availability can lead to a significant jump in the cost of credit. Investment delay means potential layoff and freeze of hiring resulting in a higher unemployment rate in the economy

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Conclusion