Correlations, Risk and Crisis: From Physiology to Finance

TL;DR

This paper explores how correlation and variance increase in systems under environmental stress, revealing a universal pattern across biological and financial systems that signals impending crises.

Contribution

It introduces a general framework explaining the increase in correlation and variance through the adaptation dynamics of similar systems facing external factors.

Findings

Correlation and variance increase before crises across systems

Experimental evidence from biological and financial data supports the effect

A theoretical model based on adaptation explains the observed phenomena

Abstract

We study the dynamics of correlation and variance in systems under the load of environmental factors. A universal effect in ensembles of similar systems under the load of similar factors is described: in crisis, typically, even before obvious symptoms of crisis appear, correlation increases, and, at the same time, variance (and volatility) increases too. This effect is supported by many experiments and observations of groups of humans, mice, trees, grassy plants, and on financial time series. A general approach to the explanation of the effect through dynamics of individual adaptation of similar non-interactive individuals to a similar system of external factors is developed. Qualitatively, this approach follows Selye's idea about adaptation energy.