Asia Regional Integration Center

Park, C. Y., and R. Mercado. 2014. Determinants of Financial Stress in Emerging Market Economies. Journal of Banking and Finance. 45. pp. 199-224.

Methodology

The 5 components of the FSI given by:

are aggregated using the variance-equal weights and principal component analysis.

1. Banking Sector (β)
   β =

   cov(r,m)

   /

   var(m)

   Where r and m are the returns to the banking sector stock price index and the overall stock price index, respectively. A higher value indicates a higher stress level in the banking sector.

2. Equity Market Returns (Stockreturns)
   γ_t = ln(γ_t) − ln(γ_t-1)

   Where γ_t is the equity return in the current period, and γ_(t-1) is the equity return in the previous period. A lower value indicates a higher stress level in the equity market.

3. Equity Market Volatility (Stockvolatility)

   The volatility follows a GARCH (1,1) process and is given by:

   σ²_t = ω + φ₁ ε²_t−1 + φ₂ σ²_t−1

   Where σ² refers to the variance, and ε the error term in the regression is given by:

   γ_t = α_i,t + βγ_t−1 + ε_i,t

   See definition of γ_t and γ_(t-1) in component 2. A higher value indicates a higher stress level in the equity market.

4. Sovereign debt spreads (Debtspreads)

   Sovereign debt spreads are used to measure sovereign debt stress. Data refer to yield differentials between long-term (10-year) local government bonds and short-term (2-year) local government bonds with available data. A wider spread indicates a higher stress level in the debt market.

5. Exchange Market Pressure Index (EMPI)
   EMPI_i,t =

   (Δe_i,t − μ_i,Δe)

   /

   σ_i,Δe

   −

   (ΔRES_i,t − μ_i,ΔRES)

   /

   σ_i,ΔRES

   The EMPI captures the depreciation of the local currency unit with respect to the United States (US) dollar and the reduction in foreign exchange reserves. A higher value indicates a higher stress level in the foreign exchange market.

   Δe and ΔRES denote month-on-month percent changes in the foreign exchange rate of the local currency unit per US dollar,and foreign exchange reserves, respectively; while σ and μ are the standard deviation and the mean, respectively.