Quantifying and modeling long-range cross correlations in multiple time series with applications to world stock indices

Scientific paper - Original scientific paper

• Author: Duan Wang
• Author: Boris Podobnik
• Author: Davor Horvatić
• Author: H. Eugene Stanley
• Author's institution: University of Zagreb; Faculty of Science; (Department of Physics)
• Scientific / art field, discipline and subdiscipline: NATURAL SCIENCES; Physics

Abstract (english)

We propose a modified time lag random matrix theory in order to study time-lag cross correlations in multiple time series. We apply the method to 48 world indices, one for each of 48 different countries. We find long-range power-law cross correlations in the absolute values of returns that quantify risk, and find that they decay much more slowly than cross correlations between the returns. The magnitude of the cross correlations constitutes “bad news” for international investment managers who may believe that risk is reduced by diversifying across countries. We find that when a market shock is transmitted around the world, the risk decays very slowly. We explain these time-lag cross correlations by introducing a global factor model (GFM) in which all index returns fluctuate in response to a single global factor. For each pair of individual time series of returns, the cross correlations between returns (or magnitudes) can be modeled with the autocorrelations of the global factor returns (or magnitudes). We estimate the global factor using principal component analysis, which minimizes the variance of the residuals after removing the global trend. Using random matrix theory, a significant fraction of the world index cross correlations can be explained by the global factor, which supports the utility of the GFM. We demonstrate applications of the GFM in forecasting risks at the world level, and in finding uncorrelated individual indices. We find ten indices that are practically uncorrelated with the global factor and with the remainder of the world indices, which is relevant information for world managers in reducing their portfolio risk. Finally, we argue that this general method can be applied to a wide range of phenomena in which time series are measured, ranging from seismology and physiology to atmospheric geophysics.

• Keywords (english): Random matrix; cross-correlations; financial world indices
• Language: english
• Publication type: Scientific paper - Original scientific paper
• Publication status: Published
• Peer review: Peer review - international
• Publication version: Published version
• Journal title: Physical Review E
• Numbering: vol. 83, no. 4, 046121
• p-ISSN: 2470-0045
• e-ISSN: 2470-0053
• DOI: https://doi.org/10.1103/PhysRevE.83.046121
• URN:NBN: urn:nbn:hr:217:859576
• Publication: 2011
• Document URL: http://link.aps.org/doi/10.1103/PhysRevE.83.046121
• Type of resource: Text
• Access conditions: Open access
• Public note: Copyright (2011) by the American Physical Society. Received 3 December 2010; published 25 April 2011.
• Created on: 2019-11-15 14:25:25