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Market Correlation and Market Volatility in US Stocks

Market Correlation and Market Volatility in US Stocks

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Published by: api-3715003 on Oct 18, 2008
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Market Correlation and Market Volatility
in US Blue Chip Stocks
Craig Mounfield (craig.mounfield@volterra.co.uk
Paul Ormerod(pormerod@volterra.co.uk
Volterra Consulting Ltd

The Old Power Station
121 Mortlake High Street
London SW14 8SN

Crowell Prize Submission
20th March 2001

We analyse the daily rates of return of US blue chip stocks over the 1993-2001 period. Using the technique of random matrix theory, we show that the correlation matrix of these rates of return is to a large extent dominated by noise rather than by true information. These results confirm for this data set findings recently documented in the econophysics literature.

However, the eigenvector associated with the principal eigenvalue of the correlation matrix does contain true information and shows stability over time. This, the market eigenvector, shows the extent to which the individual stocks tend to move together. We quantify the fraction of total information contained within this eigenmode, which we define as the information index

We find a clear positive relationship between the absolute changes in the variability of the information index and the absolute changes in the variability of the market index. Further, the absolute change in the variability of the information index lagged one day has statistically significant predictive power for the absolute change in the variability of the market index.


A precise quantification of the correlations between the returns of different assets traded in financial markets is of fundamental importance to risk management where one attempts to diversify as widely as possible the character of the portfolio (reducing exposure to sector/industry specific shocks). As a consequence of this the correlation matrix is one of the cornerstones of much of modern financial engineering such as CAPM (Elton et al, 1995) and Value at Risk.

However it is well understood that empirical measurements of the correlations between assets are subject to a number of significant sources of potential error. The difficulties associated with determining the true correlations between financial assets arise primarily due to :

\u2022 Non-stationary correlations between assets (due, for example, to an
organisations profile changing over time)
\u2022 A finite number of observations of asset price movements (the statistical

significance of spurious measurements becomes insignificant in the limit of an infinite number of observations of asset pair price movements). In this case the empirically measured correlations may be significantly noise dominated masking the true correlations between asset returns.

The technique of Random Matrix Theory (RMT) has recently been applied to financial market data to analyse the true degree of information content contained within empirical correlation matrices formed from equity returns. RMT was originally developed for the study of complex quantum mechanical systems.

In order to assess the degree to which an empirical correlation matrix is noise dominated we can compare the eigenspectra properties of the empirical matrix with the theoretical eigenspectra properties of a random matrix. Undertaking this

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