Price-quakes on stock markets

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3 november 2011 | Stock markets all over Europe plummeted after the Greek government decided to let their citizens vote on the Euro-safety package. Why do capital markets fluctuate so extremely? Research shows that stock market crashes are very comparable to earthquakes.

An international team of researchers published its research on the Open Accessplatform PLoS ONE explaining stock market disruptions with theinvestors’ tendency of change blindness. Small events would rarelybe reflected in stock prices. However, over time tension wouldbuild leading to “pricequakes” once large events occur.

Abstract on PLoS ONE:

Background

Systemic risk has received much more awareness after theexcessive risk taking by major financial institutions pushed theworld’s financial system into what many considered a state of nearsystemic failure in 2008. The IMF for example in its yearly 2009Global Financial Stability Report acknowledged the lack of propertools and research on the topic. Understanding how disruptions canpropagate across financial markets is therefore of utmostimportance.

Methodology/Principal Findings

Here, we use empirical data to show that the world’s marketshave a non-linear threshold response to events, consistent with thehypothesis that traders exhibit change blindness. Change blindnessis the tendency of humans to ignore small changes and to reactdisproportionately to large events. As we show, this may beresponsible for generating cascading events-pricequakes-in theworld’s markets. We propose a network model of the world’s stockexchanges that predicts how an individual stock exchange should bepriced in terms of the performance of the global market ofexchanges, but with change blindness included in the pricing. Themodel has a direct correspondence to models of earth tectonic platemovements developed in physics to describe the slip-stick movementof blocks linked via spring forces.

Conclusions/Significance

We have shown how the price dynamics of the world’s stockexchanges follows a dynamics of build-up and release of stress,similar to earthquakes. The nonlinear response allows us toclassify price movements of a given stock index as either beinggenerated internally, due to specific economic news for the countryin question, or externally, by the ensemble of the world’s stockexchanges reacting together like a complex system. The model mayprovide new insight into the origins and thereby also preventsystemic risks in the global financial network.