Journal of Risk

Forecasting the realized volatility of stock markets with financial stress

Chuan Guo and Yiyun Feng

  • The introduction of financial stress index in HAR model improves the five considered equity indices volatility forecast.
  • The financial stress index provides more information in predicting realized volatility of longer forecast horizons.
  • The future realized volatility of equity indices increases with the growth of financial stress index.
  • The model developed in this study performs better in the US and other advanced stock markets than in emerging markets.

We analyze the impact of financial stress on the predictability of the realized volatility (RV) of five stock markets. To this end, we develop a new volatility model by incorporating the financial stress index (FSI) into the prevailing heterogeneous autoregressive (HAR) model. The empirical analysis demonstrates that the new model significantly outperforms the benchmark HAR model, especially for longterm forecast horizons, suggesting the significant impact of financial stress on the future volatility. The future RV of equity indexes increases with the growth of the FSI. Empirical results hold true for different choices of RV estimators and loss functions.

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