Correlation Structures and Regime Shifts in Nordic Stock Markets

TL;DR

This paper investigates how correlation structures in Nordic stock markets change during crises and proposes an adaptive portfolio strategy that improves risk management during stress periods.

Contribution

It introduces a regime-aware portfolio construction method based on correlation eigenstructure dynamics and demonstrates its effectiveness through backtesting.

Findings

Crisis periods show increased leading eigenvalues and counter-cyclical second eigenvalues.

Eigenportfolio regressions support a market-factor interpretation of the dominant eigenmode.

The proposed method enhances downside protection during stress regimes.

Abstract

Financial markets are complex adaptive systems characterized by collective behavior and abrupt regime shifts, particularly during crises. This paper studies time-varying dependencies in Nordic equity markets and examines whether correlation-eigenstructure dynamics can be exploited for regime-aware portfolio construction. Using two decades of daily data for the OMXS30, OMXC20, and OMXH25 universes, pronounced regime dependence in rolling correlation matrices is documented: crisis episodes are characterized by sharp increases in the leading eigenvalue and counter-cyclical behavior in the second eigenvalue. Eigenportfolio regressions further support a market-factor interpretation of the dominant eigenmode. Building on these findings, an adaptive portfolio allocation framework is proposed, combining correlation-matrix cleaning, an eigenvalue-ratio crisis indicator and long-only minimum-variance optimization with constraints that bound exposures to dominant eigenmodes. Backtesting results indicate improved downside protection and risk-adjusted performance during stress regimes, while remaining competitive with state-of-the-art benchmarks in tranquil periods.