Examining Lead-Lag Relationships In-Depth, With Focus On FX Market As Covid-19 Crises Unfolds

TL;DR

This paper introduces a new dynamic programming-based technique to better identify and measure lead-lag relationships in financial time series, with applications to FX markets during COVID-19.

Contribution

It proposes a novel, closely related correlation measure and a loose metric for analyzing lead-lag paths, validated through synthetic tests and applied to FX market evolution during the pandemic.

Findings

FX currencies became more interconnected during COVID-19

The US dollar's central role increased in the FX market

The proposed method outperformed existing models in significance and forecast accuracy

Abstract

The lead-lag relationship plays a vital role in financial markets. It is the phenomenon where a certain price-series lags behind and partially replicates the movement of leading time-series. The present research proposes a new technique which helps better identify the lead-lag relationship empirically. Apart from better identifying the lead-lag path, the technique also gives a measure for adjudging closeness between financial time-series. Also, the proposed measure is closely related to correlation, and it uses Dynamic Programming technique for finding the optimal lead-lag path. Further, it retains most of the properties of a metric, so much so, it is termed as loose metric. Tests are performed on Synthetic Time Series (STS) with known lead-lag relationship and comparisons are done with other state-of-the-art models on the basis of significance and forecastability. The proposed technique gives the best results in both the tests. It finds paths which are all statistically significant, and its forecasts are closest to the target values. Then, we use the measure to study the topology evolution of the Foreign Exchange market, as the COVID-19 pandemic unfolds. Here, we study the FX currency prices of 29 prominent countries of the world. It is observed that as the crises unfold, all the currencies become strongly interlinked to each other. Also, USA Dollar starts playing even more central role in the FX market. Finally, we mention several other application areas of the proposed technique for designing intelligent systems.