Forecasting international financial stress: The role of climate risks
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Connects with: @hakkio2009 @hollo2012
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fava2024 - p. 1
Climate change risks are typically divided into two main components, namely physical and transition risks (Çepni et al., 2023a). While physical risks stem from the detrimental impacts of climate-related events, such as elevated temperatures, sea level rise, floods, and wildfires, transition risks arise from the gradual shift towards a low-carbon economy usually prompted by changes in climate and environmental policies, the growing competitiveness of eco-friendly technologies, and shifts in consumer preferences
fava2024 - p. 1
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fava2024 - p. 1
financial stress can be interpreted as the disruption of normal financial market operations, typically accompanied by heightened uncertainty regarding the fundamental value of financial assets (Hakkio and Keeton, 2009).
fava2024 - p. 2
To assess financial stress across the multiple regions used in this study, namely China, ten EU countries (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Netherlands, Portugal, and Spain), the UK, and the US, we rely on the financial stress indicators known as the ‘‘Composite Indicator of Systemic Stress’’ (referred to as ‘‘CISS’’), originally introduced by Holló et al. (2012).
fava2024 - p. 3
This is achieved by the application of basic portfolio theory (as originally developed by Markowitz (1959) and Sharpe (1970),4 which involves time-varying cross-correlations between the subindexes while aggregating them into the composite indicator. Hence, situations in which financial stress simultaneously beleaguers several financial market segments receive a relatively large weight in the computations of the CISS, which, in turn, reflects the idea that systemic financial stress is particularly high in times when financial instability radiates widely across the financial system.
fava2024 - p. 7
The rival models extend the benchmark model as follows: M2 features physical concerns, M3 features transition concerns, M4 features physical risk, M5 features transition risk, M6 features physical and transition concern, and M7 features physical and transition risk. The parameter h denotes the forecast horizon (in days).
fava2024 - p. 12
n essence, in line with the theory associated with rare disaster risks, we can state that climate risks, proxying for such events, indeed contain predictive power for stress of the entire financial system. But, our quantiles-based findings provides an additional layer to the results, by suggesting that a regime-specific model of the nexus between rare disaster risks and financial markets needs to be developed at the theoretical front.