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Quantifying Reflexivity in Financial Markets: Towards a Prediction of Flash Crashes

Vladimir Filimonov and Didier Sornette
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Vladimir Filimonov: ETH Zürich
Didier Sornette: Swiss Finance Institute and ETH Zürich

No 12-02, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We introduce a new measure of activity of financial markets that provides a direct access to their level of endogeneity. This measure quantifies how much of price changes are due to endogenous feedback processes, as opposed to exogenous news. For this, we calibrate the self-excited conditional Poisson Hawkes model, which combines in a natural and parsimonious way exogenous influences with self-excited dynamics, to the E-mini S&P 500 futures contracts traded in the Chicago Mercantile Exchange from 1998 to 2010. We find that the level of endogeneity has increased significantly from 1998 to 2010, with only 70% in 1998 to less than 30% since 2007 of the price changes resulting from some revealed exogenous information. Analogous to nuclear plant safety concerned with avoiding “criticality”, our measure provides a direct quantification of the distance of the financial market to a critical state defined precisely as the limit of diverging trading activity in absence of any external driving.

Keywords: complex systems; econophysics; exogenous- versus endogenous; high-frequency trading; criticality; trading activity; volume (search for similar items in EconPapers)
JEL-codes: C32 C53 G01 G14 G17 (search for similar items in EconPapers)
Pages: 24 pages
Date: 2012-02
New Economics Papers: this item is included in nep-mst
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