“Price-Quakes” in Stock Exchanges

New PLoS paper echoing some of Didier Sornette’s work on tectoni models of stress relief in financial markets:

Price-quakes in World’s Stock Exchanges

Background

Systemic risk has received much more awareness after the excessive risk taking by major financial instituations pushed the worlds financial system into what many considered a state of near systemic failure in 2008. The IMF for example in its yearly 2009 Global Financial Stability Report acknowledged the lack of proper tools and research on the topic. Understanding how disruptions can propagate across financial markets is therefore of utmost importance.

Methodology/Principal Findings

Here, we use empirical data to show that the worlds markets have a non-linear threshold response to events, consistent with the hypothesis that traders exhibit change blindness. Change blindness is the tendency of humans to ignore small changes and to react disproportionately to large events. As we show, this may be responsible for generating cascading events—pricequakes—in the worlds markets. We propose a network model of the worlds stock exchanges that predicts how an individual stock exchange should be priced in terms of the performance of the global market of exchanges, but with change blindness included in the pricing. The model has a direct correspondence to models of earth tectonic plate movements developed in physics to describe the slip-stick movement of blocks linked via spring forces.

Conclusions/Significance

We have shown how the price dynamics of the worlds stock exchanges follows a dynamics of build-up and release of stress, similar to earthquakes. The nonlinear response allows us to classify price movements of a given stock index as either being generated internally, due to specific economic news for the country in question, or externally, by the ensemble of the worlds stock exchanges reacting together like a complex system. The model may provide new insight into the origins and thereby also prevent systemic risks in the global financial network.

via PLoS ONE: “Price-Quakes” Shaking the Worlds Stock Exchanges.

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