Constructing the Financial Conditions Index for Iran's Economy and Assessing its Effects on Stock Returns by FAVAR and TVP-FAVAR Models

Raki Kianpour, Samere; Arman, Seyed Aziz; Farazmand, Hassan

doi:10.22059/ier.2024.371620.1007923

Constructing the Financial Conditions Index for Iran's Economy and Assessing its Effects on Stock Returns by FAVAR and TVP-FAVAR Models

Document Type : Research Paper

Authors

Samere Raki Kianpour

Seyed Aziz Arman

Hassan Farazmand

Department of Economics, Faculty of Economics and Social Sciences, Shahid Chamran University of Ahvaz, Ahvaz, Iran.

10.22059/ier.2024.371620.1007923

Abstract

In this study, the financial conditions index (FCI) for Iran's economy was reviewed. The factor-augmented vector autoregressive model and the factor-augmented vector autoregressive model with time-varying coefficients are used to construct FCI. The ability of the constructed index to predict various variables is also evaluated. The construction of the index and estimation of the models are based on the quarterly data for the period 1989 to 2019. The variables used included interest rate and inflation, exchange rate, consumption, banking facility, total stock market index, money supply, oil revenue, and GDP growth. The findings indicated significant volatilities in the model parameters. According to the findings, under the restriction that model parameters are time-invariant, the shock from the improvement of the financial conditions index led to a negative response to the stock market index and this effect remained for eight periods; However, with time-varying coefficients, the stock market index has responded positively to a shock in FCI, and this effect remained for 10 periods and then disappeared. Furthermore, according to the results of the in-sample prediction error, the Root Mean Square Error (RMSE) represents the high power of model prediction.

Keywords

factor augmented vector autoregressive model

financial condition index

Iran

stock returns

time-varying parameter model.

Subjects

Monetary Economics

Arrigoni, S., & Bobasu, A. (2020). The Simpler the Better: Measuring Financial Conditions For Monetary Policy And Financial Stability. European Central Bank (ECB), Working Paper Series, Retrieved from https://doi.org/10.2866/006262 .

Atrkar R., S., & Mahbobi, M. (2016). Financial Condition Index (FCI) Extraction for Iran. Journal Economic Modeling Research, 7(24), 147-173. Retrieved from http://dx.doi.org/10.18869/acadpub.jemr.6.24.147 .

Bainter, S. (2017). Bayesian Estimation for Item Factor Analysis Models with Sparse Categorical Indicator. Multivariate Behavioral Research, 52(5), 593-615. Retrieved from https://doi.org/10.1080/00273171.2017.1342203 .

Balcilar, M., Gupta, R., Eyden, R., & Thompson, K. (2018). Comparing the Forecasting Ability of Financial Conditions Indices: The Case of South Africa. The Quarterly Review of Economics and Finance, 69(C), 245-259. Retrieved from https://doi.org/10.1016/j.qref.2018.03.012 .

Beaton, K., Lalonde, R., & Luu., C. (2009). A Financial Conditions Indexes for United States. Discussion Peper 09-11, Bank of Canada. Retrieved from https://doi.org/10.34989/sdp-2009-11 .

Bernanke, B. S., Boivin, J., & Eliasz, P. (2005). Measuring the Effects of Monetary Policy: A Factor-augmented Vector Autoregressive (FAVAR) Approach. The Quarterly Journal of Economics, Oxford Academic, 120(1), 387-422. Retrieved from https://doi.org/10.1162/0033553053327452 .

Blake, A., Mumtaz, H., & Rummel, O. (2015). Measuring the Effects of Monetary Policy: the Factor-augmented VAR (FAVAR) Model. Centre for Central Banking Studies, Bank of England.

Boivin, J., Kiely, M., & Mishkin, F. (2010). How Has the Monetary Transmission Mechanism Evolved Over Time?. Handbook of Monetary Economics, 3, 369-422. Retrieved from https://doi.org/10.1016/B978-0-444-53238-1.00008-9.

Del Negro, M., & Otrok, C. (2008). Dynamic Factor Models with Time-Varying Parameters: Measuring Changes in International Business Cycles. FRB of New York Staff Report, 326. Retrieved from https://dx.doi.org/10.2139/ssrn.1136163.

Eickmeier, S., Lemke, W., & Marcellino, M. (2011). The Changing International Transmission of Financial Shocks: Evidence from a Classical Time-varying FAVAR. Deutsche Bundesbank. Discussion Paper Series 1: Economic Studies, 05/2011, 1-51. Retrieved from https://dx.doi.org/10.2139/ssrn.2785396 .

---------- (2016). The Changing International Transmission of Financial Shocks: Evidence from a Classical Time-varying FAVAR. Journal of Money Credit and Banking, 48(4), 573-601. Retrieved from https://doi.org/10.1111/jmcb.12311 .

Felices, G., & Wieladek, T. (2012). Are Emerging Market Indicators of Vulnerability to Financial Crises Decoupling from Global Factors? Journal of Banking and Finance, 36(2), 321-331. Retrieved from https://doi.org/10.1016/J.JBANKFIN.2011.06.013 .

Gauthier, C., Graham, C., & Liu, Y. (2004). Financial Conditions Indexes for Canada. Bank of Canada, Staff Working Paper, Retrieved from https://doi.org/10.34989/swp-2004-2 .

Gomez, E., Murcia, A., & Zamudio, N. )2011(. Financial Conditions Index: Early and Leading Indicator for Colombia. Essays on Economic Policy, 29(66), 174-220. [In Spanish]

Goodhart, C., & Hofmann, B. (2001). Asset Prices, Financial Conditions, and the Transmission of Monetary Policy. Federal Reserve Bank of San Francisco.

Hartigan, L., & Wright, M. (2021). Financial Conditions and Downside Risk to Economic Activity in Australia. Research Discussion Paper. Retrieved from https://doi.org/10.47688/rdp2021-03 .

Hatzius, J., Hooper, P., Mishkin, F., Schoenholtz, K., & Watson, W. (2010). Financial Conditions Indexes: A Fresh Look after the Financial Crisis. NBER Working Paper Series, 16150. Retrieved from https://doi.org/10.3386/W16150 .

Hematy, M., & Boostani, R. (2014). Constructing a New Monetary Condition Index for Iran. Monetary and Banking Research Institue, 9(3), 119-147. Retrieved from http://jme.mbri.ac.ir/files/site1/user_files_10c681/mhemmati-A-10-94-1-eda03c6.pdf.

Juhro, M., & Iyke, B. (2019). Monetary Policy and Financial Conditions in Indonesia. Bulletin of Monetary Economics and Banking, 21(3), 283–302. Retrieved from https://doi.org/10.21098/bemp.v21i3.1005.

Kapetanios, G., Price, S., & Young, G. (2018). A UK Financial Conditions Index using Targeted Data Reduction: Forecasting and Structural Identification. Econometrics and Statistics, 7(C), 1-17. Retrieved from https://doi.org/10.1016/j.ecosta.2017.12.002.

Khorsandi, M., Eslamloueyan, K., & Zonnoor., H. (2012). An Appropriate Monetary Conditions Index for The Iranian Economy. Journal of Sustainable Growth and Development (The Economic Research), 12(1), 31-57.

Koop, G., & Korobilis, D. (2014). A New Index of Financial Conditions. European Economic Review, 71(C), 101–116. Retrieved from https://doi.org/10.1016/j.euroecorev.2014.07.002 .

Korobilis, D. (2013). Assessing the Transmission of Monetary Policy Shocks using Time-varying Parameter Dynamic Factor Models. Oxford Bulletin of Economics and Statistics, 75(2), 157-179. Retrieved from https://doi.org/10.1111/j.1468-0084.2011.00687.x .

Manning, J., & Shamloo, M. (2015). A Financial Conditions Index for Greece. IMF Working Paper. Retrieved from https://doi.org/10.5089/9781513520230.001.

Mayes, D., & Viren, M. (2001). Financial Conditions Indexes. Bank of Finland Discussion Paper.

Meligotsidou, L., & Vrontos, I. (2008). Detecting Structural Breaks and Identifying Risk Factors in Hedge Fund Returns: A Bayesian approach. Journal of Banking and Finance, 32(11), 2471-2481. Retrieved from https://doi.org/10.1016/j.jbankfin.2008.05.007.

Memona, A., & Jabeen, H. (2018). Monetary Condition Index and Its Changing Transmission on Macro-economic Variables. Arab Economic and Business Journal, 13(2), 111-124. Retrieved from https://doi.org/10.1016/j.aebj.2018.10.001 .

Mohseni, H., Pahlavani, M., Shahiki Tash, M., & Mirjalili, H. (2019). Analysis of the Role of Unconventional Monetary Policy Using the Financial Conditions Index: The B-VAR Approach. Journal of Economics and Modeling, 10(1), 211-240. Retrieved from https://doi.org/10.29252/ecoj.10.1.211 .

Opschoor, A., Dick, J., & Wel, M. (2014). Predicting Volatility and Correlations with Financial Conditions Indexes. Journal of Empirical Finance, 29, 435-447. Retrieved from https://doi.org/10.1016/j.jempfin.2014.10.003.

Taheri, B. S., Ehsani, M., & Gilak Hakim Abadi, M. (2019). The Investigating of the Dynamic Relationship Between Financial Cycles with Business Cycles and the Inflation Gap in Iran: An Application of Wavelet Transform. Quarterly Journal of Economic Growth and Development Research, 9(23), 121-141. Retrieved from https://dx.doi.org/10.30473/egdr.2018.4482.

Thaghizadeh, H., Zamanian, G., & Harati, J. (2016). Financial and Monetary Conditions Index on the Iranian Economy: Principal Component Analysis. Quarterly Journal of Applied Economics Studies (AESI), 5(19), 29-57. Retrieved from https://dx.doi.org/10.22084/aes.2016.1597.

Vonen, N. H. (2011). A Financial Condition Index for Norway. Staff Memo, 07/2011, Retrieved from https://www.econstor.eu/bitstream/10419/210223/1/nb-staff-memo2011-07.pdf.