Understanding stock market instability via graph auto-encoders

TL;DR

This paper introduces a graph auto-encoder based indicator for stock market instability, showing that higher reconstruction errors correlate with increased volatility and improve out-of-sample volatility modeling.

Contribution

It proposes using graph auto-encoder edge reconstruction accuracy as a novel proxy for market volatility, enhancing financial stability analysis.

Findings

Higher GAE reconstruction error correlates with increased market volatility.

Adding GAE-based measures improves out-of-sample volatility forecasting.

The method is validated on S&P 500 data from 2015-2022.

Abstract

Understanding stock market instability is a key question in financial management as practitioners seek to forecast breakdowns in asset co-movements which expose portfolios to rapid and devastating collapses in value. The structure of these co-movements can be described as a graph where companies are represented by nodes and edges capture correlations between their price movements. Learning a timely indicator of co-movement breakdowns (manifested as modifications in the graph structure) is central in understanding both financial stability and volatility forecasting. We propose to use the edge reconstruction accuracy of a graph auto-encoder (GAE) as an indicator for how spatially homogeneous connections between assets are, which, based on financial network literature, we use as a proxy to infer market volatility. Our experiments on the S&P 500 over the 2015-2022 period show that higher GAE reconstruction error values are correlated with higher volatility. We also show that out-of-sample autoregressive modeling of volatility is improved by the addition of the proposed measure. Our paper contributes to the literature of machine learning in finance particularly in the context of understanding stock market instability.