Dynamic instability in a phenomenological model of correlated assets

Giacomo Raffaelli and Matteo Marsili

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Abstract: We show that financial correlations exhibit a non-trivial dynamic behavior. We introduce a simple phenomenological model of a multi-asset financial market, which takes into account the impact of portfolio investment on price dynamics. This captures the fact that correlations determine the optimal portfolio but are affected by investment based on it. We show that such a feedback on correlations gives rise to an instability when the volume of investment exceeds a critical value. Close to the critical point the model exhibits dynamical correlations very similar to those observed in real markets. Maximum likelihood estimates of the model's parameter for empirical data indeed confirm this conclusion, thus suggesting that real markets operate close to a dynamically unstable point.

Date: 2005-08, Revised 2006-04
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