Predicting Financial Market Crises using Multilayer Network Analysis and LSTM-based Forecasting of Spillover Effects

TL;DR

This paper introduces a novel method combining multilayer network analysis, Granger causality, Random Forest, and LSTM models to improve the prediction of financial market crises by capturing complex interdependencies and spillover effects.

Contribution

The study presents an innovative integrated approach that enhances crisis prediction accuracy by modeling intra- and inter-layer market variable dependencies using advanced machine learning techniques.

Findings

Significantly improved crisis prediction accuracy over traditional models

Effective modeling of spillover effects between market sectors

Demonstrated robustness across different financial datasets

Abstract

Financial crises often occur without warning, yet markets leading up to these events display increasing volatility and complex interdependencies across multiple sectors. This study proposes a novel approach to predicting market crises by combining multilayer network analysis with Long Short-Term Memory (LSTM) models, using Granger causality to capture within-layer connections and Random Forest to model interlayer relationships. Specifically, we utilize Granger causality to model the temporal dependencies between market variables within individual layers, such as asset prices, trading values, and returns. To represent the interactions between different market variables across sectors, we apply Random Forest to model the interlayer connections, capturing the spillover effects between these features. The LSTM model is then trained to predict market instability and potential crises based on the dynamic features of the multilayer network. Our results demonstrate that this integrated approach, combining Granger causality, Random Forest, and LSTM, significantly enhances the accuracy of market crisis prediction, outperforming traditional forecasting models. This methodology provides a powerful tool for financial institutions and policymakers to better monitor systemic risks and take proactive measures to mitigate financial crises.