Combination forecast based on financial stress categories for global equity market volatility: the evidence during the COVID-19 and the global financial crisis periods

ABSTRACT

The 2008 global financial crisis and the COVID-19 pandemic both decrease economic growth and lead to high uncertainty in global stock markets, and financial stress information is closely linked to financial crises. To improve the predictability of the realized volatility of the global equity indices during crises, we examine the predictive role of the Global Financial Stress Index (GFSI) and its categories. We find that the combination predictions based on GFSI’s five incorporated categories and three region-based categories outperform the predictions based on the raw GFSI for most indices. Specifically, the DMSPE combination model with a low discount factor has accurate forecasts for 5- and 22-day-ahead realized volatility, and it also performs better than the equal-weighted and the trimmed mean combination methods. In this study, we present a comprehensive analysis of the predictive role of financial stress information in stock market volatility during crises, and the empirical evidence provides a positive case against the ‘forecast combination puzzle’. Our findings are very instructive for policymakers and investors to make their own short-term and long-term plans in crisis.

KEYWORDS:

• Financial stress
• forecast combination
• global stock markets
• COVID-19
• global financial crisis

JEL CLASSIFICATION:

• G15
• G14

Acknowledgement

Toan Luu Duc Huynh acknowledges funding from the University of Economics Ho Chi Minh City (Vietnam) with registered project number 2023-05-04-1571. The usual disclaimers apply.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

¹ The number of the confirmed deaths due to the Coronavirus disease (COVID-19) pandemic is provided by the World Health Organization (WHO) and shown on their website of https://www.who.int/emergencies/diseases/novel-coronavirus-2019. The death number we used is as of April 2022.

² Unsustainable credit developments lead to the build-up of systemic risks to financial stability. The prices of risky assets may fall during a crisis because of investors’ extreme aversion to high risk. During a crisis, funding is harder and investors prefer safe assets, and the volatility of assets’ prices is high due to economic uncertainties.

³ They conduct their analysis by using financial stress indexes from the Office of Financial Research as same as the GFSI and its categorical indicators in this study..

⁴ https://www.financialresearch.gov/financial-stress-index/..

⁵ https://realized.oxford-man.ox.ac.uk/..

⁶ https://fred.stlouisfed.org/..

⁷ Campbell and Thompson (2008) document that the simple indicator of historical average returns outperforms many economic predictors in return predictability.