Abstract
The persistence of global financial and economic crisis of 2008-09 has compelled the policy makers to analyze the behavior of financial variables before making policy decisions. This trend has also motivated many researchers, particularly at central banks, to identify and develop some sort of composite indicator to measure the level of stress in financial markets. Pakistan’s financial sector has witnessed several reforms during the past two decades. These reforms have also paved the way for the enhancement of financial market activities, particularly during the last two decades. Development of bond market, deepening of secondary market trading, gradual liberalization of capital and foreign exchange markets are some of the broad reforms which have increased the role and impact of financial variables in economic decisions. In this backdrop, we develop a composite indicator to measure financial market stress for Pakistan. The index tries to capture the stress coming from money market, foreign exchange market and equity market based on daily observations. The constructed index captures quite well all the known periods of stress like situations in Pakistan’s financial market during the selected sample period. Importantly, from the policy perspective, and to keep it simple, few definitions are suggested to identify moderate or highly stressful periods based on index values. The rest of the note is organized as follows. The next section briefly discusses the available literature on the construction of financial stress indicators. The third section indentifies some major differences between financial stress and financial condition indices; another important concept that emerged during the recent global financial crisis. The fourth section describes the construction and development of the financial stress indicator for Pakistan. The fifth section makes the concluding remarks.