Plunges in the Bombay stock exchange: Characteristics and indicators

TL;DR

This paper analyzes eight years of BSE data, revealing how sector correlations and PE ratios behave differently during normal times and crashes, and proposing indicators for impending market crashes.

Contribution

It introduces a model using PE ratio and cross correlation eigenvalues to predict financial market crashes based on empirical data.

Findings

PE ratio shows distinctive trends before crashes

Cross correlation eigenvalues increase during crises

Proposed model can potentially predict market downturns

Abstract

We study the various sectors of the Bombay Stock Exchange (BSE) for a period of eight years from January 2006 to March 2014. Using the data of the daily returns of a period of eight years we investigate the financial cross correlation co-efficients among the sectors of BSE and Price by Earning (PE) ratio of BSE Sensex. We show that the behavior of these quantities during normal periods and during crisis is very different. We show that the PE ratio shows a particular distinctive trend in the approach to a crash of the financial market and can therefore be used as an indicator of an impending catastrophe. We propose that a model of analysis of crashes in a financial market can be built using two parameters: (i) the PE ratio and (ii) the largest eigenvalue of the cross correlation matrix.