BofA Merrill Lynch Unveils Stress Index

BofA Merrill Lynch Global Research introduced the Global Financial Stress Index (GFSI), a cross-market gauge of risk, hedging demand and investment flows.

A news release said the index is designed to help investors identify market risks earlier and more accurately than commonly used risk indicators, such as the VIX index.

The GFSI composite index aggregates over twenty measures of stress across five asset classes and various geographies. It measures three separate kinds of financial market stress: risk, as indicated by cross-asset measures of volatility, solvency and liquidity; hedging demand, implied by the skew of equity and currency options; and investor appetite for risk, as measured by trading volumes as well as flows in and out of equities, high-yield bonds and money markets.

Back-testing of the GFSI since 2000 illustrates that sharp rises in the index over short periods of time would have had a high degree of accuracy in forecasting selloffs in assets, particularly global equities, commodities and U.S. high-yield bonds, the news release said.

The GFSI’s sub-components illustrate differences in market, solvency, liquidity, and tail risk that are priced daily into financial markets. This can help uncover relative value opportunities across assets and their derivatives, as well as allow investors to identify the cheapest tail hedges. Differences between sub-indices measuring investment flows and broader market health can also help detect significant market turning points and contrarian “buy” signals.

“Since the global financial crisis, risk appears to have become as important to investors as return,” said Michael Hartnett, chief Global Equity strategist at BofA Merrill Lynch Global Research, in the news release. “The GFSI measures risks not normally visible in public markets by incorporating assets trading in the over-the-counter market. We believe its breadth and depth make it a better measure of financial market stress than the VIX, which is based on U.S. options data alone.”

Currently, the GFSI is 0.26 which indicates marginally elevated market stress, the announcement said. The Flow sub-index touched a two-year low earlier this month indicating large inflows into risky assets and out of money market funds. This optimistic positioning contrasts with stress levels signaled by both the Risk and Skew sub-indices, which remain elevated. The last time such a similar discrepancy between Skew and Flows occurred was in April 2010, just before a sharp decline in the S&P 500.