Economics Letters 125 (2014) 101–106

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Economics Letters
journal homepage: www.elsevier.com/locate/ecolet

Measuring stress in money markets: A dynamic factor approach✩

Seth Carpenter a , Selva Demiralp b , Bernd Schlusche a , Zeynep Senyuz a,∗
a
Federal Reserve Board, Division of Monetary Affairs, 20th and Constitution Ave. NW, Washington, DC 20551, USA
b
Koc University, Department of Economics, Rumeli Feneri Yolu, Sarıyer, Istanbul 34450, Turkey

highlights
• We develop an index to monitor money market stress in real-time.
• We model cyclical phases of the money market during the 2007–2009 financial crisis using a Markov-switching dynamic factor model.
• Switches to lower stress regimes appear to be associated with nonstandard policy measures by the Fed.

article info abstract

Article history: We extract an index of interest rate spreads from various money market segments to assess the level of
Received 21 May 2014 funding stress in real time. We find that during the 2007–2009 financial crisis, money markets switched
Received in revised form between low and high stress regimes except for brief periods of extreme stress. Transitions to lower stress
11 August 2014
regimes are typically associated with the non-standard policy measures by the Federal Reserve.
Accepted 14 August 2014
Available online 23 August 2014
Published by Elsevier B.V.

JEL classification:
C32
E44

Keywords:
Money market
Dynamic factor models
Markov-switching
Financial crisis

1. Introduction
Money markets provide liquidity for the global financial system
by facilitating the borrowing and lending by financial institutions
for short periods of time. Since stress in these markets may block
the flow of funding to the entire financial system, gauging the level
of such stress is crucial for policy makers.
Many indexes that aggregate information from various financial
variables have been constructed to measure broad financial stress
rather than short-term funding stress that we consider in this
paper (see Hakkio and Keaton, 2009, Kliesen and Smith, 2010, Oet
✩ The analysis and conclusions set forth are those of the authors alone and do not
indicate concurrence by the Federal Reserve Board or other members of the research
staff.
∗ Corresponding author. Tel.: +1 202 973 7499.
E-mail addresses: seth.b.carpenter@frb.gov (S. Carpenter), sdemiralp@ku.edu.tr
(S. Demiralp), bernd.schlusche@frb.gov (B. Schlusche), zeynep.senyuz@frb.gov
(Z. Senyuz).
http://dx.doi.org/10.1016/j.econlet.2014.08.017
0165-1765/Published by Elsevier B.V.
et al., 2011, Brave and Butters, 2011, Illing and Liu, 2006, Matheson,
2012, and Hollo et al., 2012, among others). Several financial
stress indexes are constructed by simply averaging a wide range
of variables using equal weights or weights based on the relative
sizes of the underlying markets. Others use a principal components
approach that allows some variables to be more closely related to
financial stress than others. A more flexible approach, which we
adopt in this paper, is to estimate a dynamic factor model that
allows for the relationship between the unobserved factor and the
observable data to change over time.
Instead of focusing on broad financial stress, our index provides
a more refined perspective on money markets which are at the
core of the financial system. Because stress seems to appear first
in money markets as in the case of 2007–2009 crisis, our index is
expected to pick up the first signs of funding strains before they
affect the entire financial system. Using a dynamic factor frame-
work, we extract a common factor of interest rate spreads that
are representative of conditions in different money market seg-
ments. In order to shed light on the crisis period and capture sub-
stantially different market dynamics during that period, we also
102 S. Carpenter et al. / Economics Letters 125 (2014) 101–106

estimate a Markov-switching dynamic factor model for the cri- Table 1

sis sub-period. We identify three distinct phases of stress charac- Maximum likelihood estimates of the linear model January 2002–November 2013.

terized by mean and variance asymmetries. We find that money Factor equation Factor loadings Idio. std. dev.
markets switched between low and high stress regimes dur- parameters
ing the crisis except for brief periods of extreme stress such as φ1 0.97 β2 0.23 σu1 0.04
that following Lehman Brothers’ bankruptcy in the fall of 2008. (108.3) (6.6) (20.8)
The timing of the switches between regimes suggests that the σv 0.07 β3 0.34 σu2 0.05
(26.3) (9.2) (34.8)
non-standard policy measures used by the Federal Reserve at dif- β4 1.49 σu3 0.15
ferent stages of the crisis have been effective in reducing funding Idio. AR(1) parameters (26.0) (34.9)
stress. ψ1 0.99 β5 0.94 σu4 0.06
Section 2 describes the money market spreads used to construct (120.9) (10.3) (24.6)
our index. Section 3 presents the linear and nonlinear dynamic ψ2 0.99 β6 0.50 σu5 0.13
factor models and summarizes the estimation results. Section 4 (222.9) (23.4) (34.2)
ψ3 0.43 β7 1.22 σu6 0.05
concludes.
(11.7) (22.9) (29.2)
ψ4 0.98 σu7 0.06
2. Key variables of money market stress (121.9) (26.3)
ψ5 0.97
Even though different segments of the money market are linked (96.9)
with one another, and rates generally tend to move together, the ψ6 0.17
(2.9)
segments have distinct characteristics depending on the type of ψ7 0.90
instrument being traded and the terms of the trade. For example, (43.2)
borrowing in the repo market is secured, while borrowing in Note: t-statistics are provided in parenthesis.
the federal funds market is unsecured. Therefore, an increase
in counterparty risk may manifest itself in a widening spread
between unsecured and secured funding rates. where α is an 8 × 1 vector that includes the drift term; F is an 8 × 8
We consider the following money market spreads from January matrix of autoregressive parameters; and Q = GQ ∗ G′ with Q ∗ be-
2002 to November 2013 at a weekly frequency: (1) the three- ing the diagonal matrix that includes the variance of the common
month Libor–OIS spread; (2) the spread between three-month factor and the seven idiosyncratic component variances in its di-
forward rate agreements (FRA) and the OIS rate; (3) the spread agonal, i.e., Q ∗ = diag(σv2 , σu1
2
, . . . , σu7
2
) and G = I8 . We cast this
between the federal funds and Treasury general collateral repo model in state space and use the Kalman filter to obtain optimal
rates; (4) the TED spread, that is, the spread between three-month extractions of the state of money market.
Libor and the Treasury bill yield; (5) the spread between interest The extracted index from January 2002 to November 2013 is
rates on low quality A2/P2 and high quality AA 30-day nonfinancial plotted in Fig. 1.1 Panel A shows the index from January 2002 until
commercial paper; (6) the spread between AA unsecured financial the end of 2006 during which it fluctuates within a narrow band
commercial paper and AA unsecured nonfinancial commercial around 0.05, indicating no stress in money markets. Panel B plots
paper; and (7) the spread between asset-backed commercial paper the index from January 2007 to December 2008. In August 2007,
and AA unsecured nonfinancial paper. the index increased to levels over ten times its long-run average
The Libor–OIS spread and the federal funds rate–repo spread and exceeded 0.5 by mid-month. This period is characterized by
serve as measures for counterparty risk. The FRA–OIS spread is wide fluctuations associated with varying levels of funding stress.
considered as a measure of expected counterparty risk. The TED The index reached its peak value of 2.64 in mid-October 2008,
spread measures the perceived risk in lending to banks relative to following the bankruptcy of Lehman Brothers. Panel C shows the
investments in relatively safe Treasury bills. The remaining three index for 2009, during which time the stress in money markets
spreads serve as measures of risk premiums on different products had declined, with the most notable reduction being observed
in the commercial paper market. following the FOMC announcement that the Federal Reserve
would conduct additional asset purchases. From January 2010 to
3. Methodology and results November 2013, as shown in Panel D, the index mostly fluctuates
around its pre-crisis average except for two brief episodes. The
3.1. A common factor of money market stress first episode in mid-2010 coincides with the downgrade of Greek
government debt to junk-bond status. The second episode is in
We construct an index of money market stress using a dynamic late 2011 amid the US debt ceiling crisis, the downgrade of US
factor model that filters out the idiosyncratic noise inherent in each government debt, and the increased risks and funding stress
series. Let Zt be the 7 × 1 vector of observable money market abroad due to the sovereign debt crisis. The index declined to
variables: Zt′ = [LIBOR–OIS, FRA–OIS, FFR–Repo, TED, A2P2–AA, below zero in early 2012 and has remained there since.
AAF–AANF, AAAB–AANF]. The measurement equation that estab- The maximum likelihood estimates of the linear dynamic factor
lishes the relation between the observable series and the unob- model are presented in Table 1. The common factor is very
served state variables is given by, persistent with an AR(1) coefficient of 0.97. All factor exposures
Zt = H βt , (1) are positive and statistically significant. Significant autoregressive
coefficient estimates and standard errors for the idiosyncratic
where βt is the 8 × 1 vector of unobservable factors including the
components suggest variable-specific dynamics in all series after
common factor and the idiosyncratic components of the observ-
their common variation is accounted for.
able variables and H is the 8 × 7 matrix of factor loadings that re-
flect how each observable variable is related to the common factor.
We assume that the common factor and the idiosyncratic com-
ponents follow parsimonious AR(1) processes. Their dynamics are 1 The index is extracted from various spreads that are in percentage terms. The
specified in the transition equation: full-sample average value of the index is 0.13, with a minimum of −0.06 and a
maximum of 2.64. Progressively higher positive values indicate progressively worse
βt = α + F βt −1 + ξt and E (ξt ξt′ ) = Q , (2) than average conditions.
 S. Carpenter et al. / Economics Letters 125 (2014) 101–106 103

Panel A Panel B
0.15 3.00
Weekly Weekly
0.14
2.75
0.13
2.50
0.12
0.11 2.25

0.10 2.00
0.09
1.75
0.08
1.50
0.07
0.06 1.25

0.05 1.00
0.04
0.75
0.03
0.50
0.02
0.01 0.25

0.00 0.00

2002 2003 2004 2005 2006 2007 2008

Panel C Panel D
0.55 0.20
Weekly Weekly
0.18
0.50
0.16
0.45
0.14
0.40
0.12
0.35 0.10

0.30 0.08

0.25 0.06

0.04
0.20
0.02
0.15
0.00
0.10
-0.02

0.05 -0.04

0.00 -0.06

2009 2010 2011 2012 2013

Fig. 1. The money market stress index.

3.2. Money market stress during the financial crisis states following a first order 3-state Markov process given by,
3

Dynamics of the US money market substantially changed during pij = P [St = j|St −1 = i] and pij = 1. (3)
the 2007–2009 financial crisis with unprecedented jumps in the j =1

commonly monitored rate spreads. In order to capture cyclical dy-
namics during the crisis, we extend the above described model to
account for potential mean and variance asymmetries and fit it to
the sub-sample from May 2007 to June 2009. Eq. (2) is replaced by,
βt = αSt + F βt −1 + ξt and E (ξt ξt′ ) = QSt ,
where QSt = GQ ∗St G′ and QS∗t = diag(σv2S , σu1
2
, . . . , σu11
2
). The drift
t
terms and the factor variance are assumed to switch between
We estimate the model using a nonlinear version of the Kalman
filter and Hamilton’s (1989) filter along with Kim’s (1994) approx-
imate maximum likelihood method. The factor and the regime
probabilities are then estimated based on information at each point
in time.2
(2′ )
2 See Kim (1994) for details on the estimation of dynamic factor models. A
comprehensive survey and various applications of this approach can be found in
Kim and Nelson (1999).
104 S. Carpenter et al. / Economics Letters 125 (2014) 101–106

Fig. 2. Smoothed probabilities.

Table 2 presents the estimation results. The first state, the low-
stress regime, has a mean of 0.04. The second state has a mean of
0.18, and represents the high-stress regime. The third state, which
we refer to as the extreme-stress state, has a mean of 0.44, and
prevails for only 16 weeks. This state is also the most volatile state,
followed by the high- and low-stress states.
The smoothed probabilities of high- and extreme-stress regimes
during the crisis period are plotted in Panels A and B of Fig. 2,
respectively. The vertical, dashed green lines indicate cuts in the
federal funds rate. We see from Panel A that the beginning of
the crisis in August 2007 is associated with a switch to the high-
stress regime. Subsequently, the index switches between high- and
low-stress regimes for most of the crisis, except for a very brief pe-
riod of extreme stress in December 2007, and the 16-week period
following Lehman Brothers’ bankruptcy which were characterized
by intensified market pressures that diminished liquidity in the
funding markets. Stress remained very high until mid-December
2008. Most switches from high to low stress regimes are associated
 S. Carpenter et al. / Economics Letters 125 (2014) 101–106 105

Fig. 3. The money market stress index, the Cleveland Financial Stress Index, and the National Financial Conditions Index.

Table 2 with the announcements of Federal Reserve interventions, such as

Maximum likelihood estimates of the non-linear model for the crisis period May the Term Auction Facility (TAF) and the first round of large-scale
2007–June 2009.
asset purchases (LSAP1), as well as with the announcement of the
Factor equation Factor loadings Idio. std. dev. Treasury’s Troubled Asset Relief Program (TARP). Moreover, de-
parameters clines in the index following rate cuts during the crisis appear to
φ1 0.71 β2 0.20 σu1 0.09 be smaller than the declines following the implementation of non-
(12.57) (3.15) (8.47) standard policy measures, perhaps suggesting that, during times
µ1 0.04 β3 0.32 σu2 0.09 of elevated market stress, non-standard measures have been more
(2.01) (4.14) (14.75) effective in taming money market pressures.
µ2 0.18 β4 1.41 σu3 0.33
Finally, we take a look at how our money market stress index
(4.92) (10.60) (14.95)
compares with broader measures that are designed to measure
µ3 0.44 β5 1.02 σu4 0.16
(3.53) (4.97) (11.36)
stress in the entire financial system. Fig. 3 plots our money mar-
σv 1 0.00 β6 0.50 σu5 0.30 ket stress index for the 2007–2009 crisis period along with the
(0.06) (9.97) (14.71) Cleveland Financial Stress Index (CFSI) and the National Financial
σv 2 0.03 β7 1.32 σu6 0.11 Conditions Index (NFCI) of the Chicago Federal Reserve.3 Our index
(1.62) (9.91) (13.95) increases well above its long-run average from August 2007 until
σv 3 0.35 σu7 0.11 early 2009, and identifies episodes with varying degrees of fund-
(5.32) (8.34) ing strains during this time. The two financial indexes appear to
Transition probs. Idio. AR(1) parameters have upward trends for most of the crisis period and they remain
p11 0.95 ψ1 0.98 at substantially higher levels at the end of the sample relative to
(34.81) (54.93) where they were before the crisis started. Our index reaches its
p12 0.05 ψ2 0.99 peak right around the outburst of the second wave of the crisis fol-
(1.71) (74.67) lowing Lehman Brothers’ bankruptcy. This is followed by the peak
p21 0.00 ψ3 0.38 in the NFCI that reflects broader financial stress. In contrast, the
(0.01) (4.36)
CFSI peaks after money markets had calmed down considerably. As
p22 0.91 ψ4 0.97
suggested by our index, funding strains in money markets largely
(18.82) (38.40)
p31 0.19 ψ5 0.97 disappeared in early 2009, but stress in the broader financial sys-
(1.94) (41.90) tem persisted according to financial indexes.
p32 0.00 ψ6 0.27
(0.01) (2.56)
ψ7 0.92
3 These two indexes are chosen for the illustration because they are also available
(18.63)
at the weekly frequency. The majority of the other financial stress indexes in the
Note: t-statistics are provided in parenthesis. literature are only available at lower frequencies.
106 S. Carpenter et al. / Economics Letters 125 (2014) 101–106
4. Concluding remarks
Using a dynamic factor framework, we construct a money mar-
ket stress index, which may be used by policy makers to gauge the
level of short-term funding stress and assess the need for possible
policy interventions.
For the financial crisis period, we estimate a nonlinear dynamic
factor model and identify three different states of money market
stress characterized by mean and variance asymmetry. Funding
conditions switch between low and high stress regimes except for
brief periods during which funding stress reaches at extreme lev-
els. Switches to lower-stress regimes are generally associated with
the non-standard policy actions by the Federal Reserve, suggesting
that these measures have been effective in taming money market
pressures.
Acknowledgments
We are grateful to colleagues at the Board of Governors as well
as participants at the 2012 International Finance and Banking So-
ciety Annual Conference and the 2012 ECB workshop on excess
liquidity and money market functioning, especially our discussant
Manfred Kremer, for helpful comments. Demiralp’s research was
funded by the European Commission’s Marie Curie International
Outgoing Fellowship (Project No: 273677). We thank Francesca
Cavalli for excellent research assistance.
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