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The GFSI composite index aggregates over twenty 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.

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 sell-offs in assets, particularly global equities, commodities and U.S. high-yield bonds.

“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.”

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.

“Understanding diverse sources of global financial stress has become increasingly important in today's markets,” added Benjamin Bowler, global head of Equity Derivatives at BofA Merrill Lynch Global Research. “Knowing which risks are important and, more importantly, how to hedge them without overpaying is key to successful investing. The GFSI can be an important tool for traders, investors and asset-allocators to make better investment and risk management decisions across asset classes.”

Currently, the GFSI is .26 which indicates marginally elevated market stress. 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.

(press release)

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