BofA Merrill Lynch Global Research has introduced a new index designed to help investors identify market risks earlier and more accurately than other commonly used risk indicators.

The Global Financial Stress Index aggregates over 20 measures of stress across five asset classes and various geographies, measuring 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.

Merrill reports that back-testing of the index since 2000, “illustrates that sharp rises in the index over short periods of time would have had a high degree of accuracy in forecasting sell-offs in assets, particularly global equities, commodities and U.S. high-yield bonds”. Currently, the index indicates marginally elevated market stress, it reports.

Additionally, it says that the GFSI’s sub-components illustrate differences in market, solvency, liquidity, and tail risk, which 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, it adds.

The new index is competing against the more established volatility index on the Chicago Board Options Exchange, the VIX Index.

“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. “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.”

IE