Dynamics of market states and risk assessment

TL;DR

This paper introduces a new method for identifying and analyzing market states based on correlation structures and transition dynamics, enhancing risk assessment and market visualization during the pre-COVID-19 period.

Contribution

It proposes modifications to market state classification criteria emphasizing transition matrix stability, and introduces a trajectory-based visualization of market dynamics in correlation space.

Findings

Significant results for SP 500 and Nikkei 225 markets (2006-2019)

Improved risk assessment through dynamic market state analysis

Visualization of market trajectories in reduced dimensions

Abstract

Previous research explored various conditions of financial markets based on the similarity of correlation structures and classified as market states. We introduce modifications to previous selection criteria for these market states, mainly due to increased attention to the transition matrix between the states. Clustering and thus market states are fixed by the optimization of two parameters -- number of clusters and noise suppression, but in similar conditions, we give preference to the clustering which avoids large jumps in the transition matrix. We found statistically significant results applying this model to the SP 500 and Nikkei 225 markets for the pre-COVID-19 pandemic era (2006-2019). Retaining the epoch length of 20 trading days but reducing the shift of the epoch to a single trading day we are led to the concept of a trajectory of the market in the space of correlation matrices. We may visualize these states after dimensional scaling to two or three dimensions. This approach, using dynamics, improves the options of risk assessment, opens the door to dynamical treatments of markets (e.g. hedging), and shows noise suppression in a new light.