Ecoinometrics - Risk and financial conditions

Financial conditions are the key to understand risk assets.

In an economic system that is highly reliant on debt the availability of credit has a strong influence on the financial markets.

This is especially true of risk assets and digital assets.

Keeping track of the financial conditions is essential to manage your risk and to anticipate the performance of your portfolio.

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Risk and financial conditions

In the last issue of the newsletter we introduced the Financial Conditions Index compiled by the Federal Reserve Bank of Chicago.

The idea is that this index tracks the financial conditions, i.e. credit conditions, in the real economy.

Naturally you'd think that loose financial conditions are "short term good" for risk assets and business in general. Conversely tight financial conditions should mean that times are harder.

Is it the case though? I mean are those metrics good enough to show a quantitative relationship between the performance of risk assets and the financial conditions?

The answer is yes. Broadly speaking the periods categorized as loose or tight according to the financial conditions index do correlate with return and volatility characteristics on risk assets.

But don't take my word for it while we can look directly at the data.

Let's do that right now.

When we are talking index we always have to worry about the base level effect to do a correct interpretation of its value. 

So for this analysis we are going to rely on the relative values of the financial conditions index. That is we divide the values of the financial conditions index in percentile chunks with:

• The lower percentiles corresponding to looser conditions.

• The higher percentiles corresponding to tighter conditions.

If we take the distribution of this financial conditions index over the past 50 years and break it down in quintiles (20% chunks) it looks like this.