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Constructing a financial conditions index for the United Kingdom: A comparative analysis

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  • Sheng Zhu
  • Ella Kavanagh
  • Niall O'Sullivan

Abstract

We investigate the optimal constituent variable weighting method for a UK financial conditions index (FCI) using a small number of financial indicators. The criterion for choosing the optimal weighting model concentrates on the index's ability to predict economic activity. We develop a “two‐step” process as a new weighted‐sum method and show that it is superior to other existing weighted‐sum models in creating an FCI. For comparative purposes, we create another FCI using a time‐varying parameter factor‐augmented vector autoregressive (TVP‐FAVAR) with stochastic volatility model as a principal‐component method. The results suggest that the TVP‐FAVAR model is the best variable‐weighting model to create an FCI in relation to its purpose of forecasting developments in the economy.

Suggested Citation

  • Sheng Zhu & Ella Kavanagh & Niall O'Sullivan, 2021. "Constructing a financial conditions index for the United Kingdom: A comparative analysis," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 26(2), pages 2976-2989, April.
    • Handle: RePEc:wly:ijfiec:v:26:y:2021:i:2:p:2976-2989
    DOI: 10.1002/ijfe.1945
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