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Kimmo SoramäkiFounder and CEO of Financial Network Analytics (FNA)
This material is the intellectual property of the presenterand shall not be reproduced or used without the express written permission .
Financial CartographyFebruary 6, 2013 – 12 p.m. U.S. Eastern Time
Financial Cartography
Dr. Kimmo SoramäkiFounder and CEOFNA, www.fna.fi
PRMIA Webinar6 February 2013
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“When the crisis came, the serious limitations of existing economic and financial models immediately became apparent. [...] As a policy-maker during the crisis, I found the available models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.”
in a Speech by Jean-Claude Trichet, President of the European Central Bank, Frankfurt, 18 November 2010
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We did not have maps …
5Eratosthenes' map of the known world c. 194 BC
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… but what are maps
“A set of points, lines, and areas all defined both by position with reference to a coordinate system and by their non-spatial attributes”
Data is encoded as size, shape, value, texture or pattern, color and orientation of the points, lines and areas – everything has a meaning
Political map of Europe
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… but what are maps (contd.)
Cartographer selects only the information that is essential to fulfill the purpose of the map
Maps reduce multidimensional data into a two dimensional space that is better understood by humans
Maps are intelligence amplification, they aid in decision making and build intuition
Map by John Snow showing the clusters of cholera cases in the London epidemic of 1854
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I. Mapping Systemic Risk
II. Mapping Financial Markets
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Systemic risk ≠ systematic risk
The risk that a system composed of many interacting parts fails (due to a shock to some of its parts).
In Finance, the risk that a disturbance in the financial system propagates and makes the system unable to perform its function – i.e. allocate capital efficiently.
Domino effects, cascading failures, financial interlinkages, … -> i.e. a process in the financial network
News articles mentioning “systemic risk”, Source: trends.google.com
Not:
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Network Theory can be to Financial Maps what Cartography is to Geographic Maps
Main premise of network theory: Structure of links between nodes matters
To understand the behavior of one node, one must analyze the behavior of nodes that may be several links apart in the network
Topics: Centrality, Communities, Layouts, Spreading and generation processes, Path finding, etc.
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Network aspect is an unexplored dimension of data
Variables
Obs
erva
tions
Time
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First Maps Fedwire Interbank Payment Network, Fall 2001
Around 8000 banks, 66 banks comprise 75% of value,25 banks completely connected
Similar to other socio-technological networks
Soramäki, Bech, Beyeler, Glass and Arnold (2007), Physica A, Vol. 379, pp 317-333.See: www.fna.fi/papers/physa2007sbagb.pdf
M. Boss, H. Elsinger, M. Summer, S. Thurner, The network topology of the interbank market, Santa Fe Institute Working Paper 03-10-054, 2003.
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Source: Bech, M.L. and Atalay, E. (2008), “The Topology of the Federal Funds Market”. ECB Working Paper No. 986.
More Maps: Federal Funds1997 - 2006
• 2600 loans worth $335 billion per day
• First Circle: 165Second Circle: 271Rest: 42
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Source: Iori G, G de Masi, O Precup, G Gabbi and G Caldarelli (2008): “A network analysis of the Italian overnight money market”, Journal of Economic Dynamics and Control, vol. 32(1), pages 259-278
More Maps: Italian money market
Italian (very small)Italian (small)Italian (large)Foreign
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More Maps: DebtRank
Source: Battiston et al, Nature Scientific Reports 2-54, 2012
Nodes: Financial institutionsLinks: Impact of an institution to another
Nodes closer to center are more important (as are big and red)
August 2007 to April 2008 October 2008 to April 2010
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Where are we today?
Regulatory response to recent financial crisis was to strengthen macro-prudential supervision with mandates for more regulatory data
“Big data” and “Complex Data”-> Providing tools and challenge to understand, utilize and operationalize the data
Financial Networks are starting to get their own literature and metrics different from other fields of Network Theory
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Case: Oversight Monitor
The monitor will allow the identification of systemically important banks and evaluation of the impact of bank failures on the interbank payment system
(network is fictional)
Intraday Liquidity Network -example
The visualizations are available at www.fna.fi/webinar/prmia
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Polling Question 1
Which types of networks are most important for financial institutions and regulators?
1) Exposure/contagion networks2) Trade/payment networks3) Supply chain networks4) Social networks
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II. Mapping Financial Markets
I. Mapping Systemic Risk
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Outline
Purpose of the maps– Identify price driving themes and
market dynamics – Reduce complexity– Spot anomalies– Build intuition
The maps: Heat Maps, Trees, Networks and Sammon’s Projections
Based on asset correlations or tail dependence
These methods are showcased for visualizing markets around the collapse of Lehman Brothers
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Collapse of Lehman
Lehman was the fourth largest investment bank in the US (behind Goldman Sachs, Morgan Stanley, and Merrill Lynch) with 26.000 employees
At bankruptcy Lehman had $750 billion debt and $639 billion assets
Collapse was due to losses in subprime holdings and inability to find funding due to extreme market conditions
Is seen as a divisive point in the 2007-2009 financial crisis
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The DataPairwise correlations of return on 118 global assets in 4 asset classes
• Stock Exchange Indices (e.g. Dow Jones)
• Foreign Exchange Rates (e.g EUR/USD)
• Government Bonds (e.g. Irish 10 year bond)
• Corportate Bonds (e.g. EMU Corporate AAA, 1-3 years)
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Corporate Bonds
FX Rates
Government Bond Yields
Stock Exchange Indices
January 2007
-1
0
+1
Correlation
i) Heat Maps
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t-2 t-1January 2007
t+1 t+2
Corporate Bonds
FX Rates
GovernmentBonds
Stocks
Corporate Bonds
FX Rates
GovernmentBonds
Stocks
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ii) Asset Trees
Originally proposed by Rosario Mantegna in 1999
Used currently by some major financial institutions for market analysis and portfolio optimization and visualization
Methodology in a nutshell
1. Calculate (daily) asset returns2. Calculate pairwise correlations of returns3. Convert correlations to distances4. Extract Minimum Spanning Tree (MST)
5. Visualize
Minimum Spanning TreeA spanning tree of a graph is a subgraph that: 1. is a tree and 2. connects all the nodes together
Length of a tree is the sum of its links. Minimum spanning tree (MST) is a spanning tree with shortest length.
MST reflects the hierarchical structure of the correlation matrix
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Demo: Asset Trees
Color of node denotes asset class:
Links between nodes reflect 'backbone' correlations
- short link = high correlation- long link = low correlation
Size of node reflects volatility (variance) of returns
Dow Jones
EUR/USD
Ireland 10 year government bond
EMU Corporate AAA, 1-3 years
The visualizations are available at www.fna.fi/webinar/prmia
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Correlation filtering
Balance between too much and too little information, signal vs noise
One of many methods to create networks from correlation/distance matrices
– PMFGs, Partial Correlation Networks, Influence Networks, Granger Causality, NETS, etc.
New graph, information-theory, economics & statistics -based models are being actively developed
PMFG
Influence Network
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iii) NETS
• Network Estimation for Time-Series
• Forthcoming paper by Barigozzi and Brownlees
• Estimates an unknown network structure from multivariate data
• Based on partial correlations
• Captures both comtemporenous and serial dependence (partial correlations and lead/lag effects)
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iv) Sammon’s Projection
Iris Setosa
Iris Versicolor
Iris Virginica
Proposed by John W. Sammon in IEEE Transactions on Computers 18: 401–409 (1969)
A nonlinear projection method to map a high dimensional space onto a space oflower dimensionality. Example:
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Demo: Sammon Projection
Color of node denotes asset class:
Distance between nodes reflects similarity of correlation profiles- close = similar- far apart = different
Size of node reflects volatility (variance) of returns
Dow Jones
EUR/USD
Ireland 10 year government bond
EMU Corporate AAA, 1-3 years
The visualizations are available at www.fna.fi/webinar/prmia
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Tail dependence
• Correlation is a linear dependence. The same visual maps can be extended to non-linear dependences.
• Joint work with Firamis (Jochen Papenbrock) and RC Banken (Frank Schmielewski), see www.extreme-value-theory.com
• Instead of correlation, links and positions measure similarity of distances to tail losses
Tail Tree(Click here for interactive visualization)
Tail Sammon (click here for interactive visualization)
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Polling Question
Where can financial data visualization provide most value?
1. Data validation and exploration2. Enhancing intuition3. Add on to statistical analysis4. Risk Management5. Trading
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“In the absence of clear guidance from existing analytical frameworks, policy-makers had to place particular reliance on our experience. Judgment and experience inevitably played a key role.”
in a Speech by Jean-Claude Trichet, President of the European Central Bank, Frankfurt, 18 November 2010
Blog, Library and Demos at www.fna.fi
Dr. Kimmo Soramäki [email protected]: soramaki
To learn more about this topic and attend a live training course with Dr. Kimmo Soramaki, please click on the following course session for more information and how to register.
FINANCIAL NETWORKS – LESSONS FOR RISK MANGEMENT
NEW YORKApril 26, 2013
One-Day Training Course
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