Interpreting Financial Market Crashes as Earthquakes: A New Early Warning System for Medium Term Crashes

Tinbergen Institute Discussion Paper 14-067/III

48 Pages Posted: 24 Jul 2014

See all articles by Francine Gresnigt

Francine Gresnigt

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)

Erik Kole

Erasmus University Rotterdam - Erasmus School of Economics - Econometric Institute; ERIM; Tinbergen Institute

Philip Hans Franses

Erasmus University Rotterdam (EUR) - Department of Econometrics

Date Written: June 1, 2014

Abstract

We propose a modeling framework which allows for creating probability predictions on a future market crash in the medium term, like sometime in the next five days. Our framework draws upon noticeable similarities between stock returns around a financial market crash and seismic activity around earthquakes. Our model is incorporated in an Early Warning System for future crash days. Testing our EWS on S&P 500 data during the recent financial crisis, we find positive Hanssen-Kuiper Skill Scores. Furthermore our modeling framework is capable of exploiting information in the returns series not captured by well known and commonly used volatility models. EWS based on our models outperform EWS based on the volatility models forecasting extreme price movements, while forecasting is much less time-consuming.

Keywords: Financial crashes, Hawkes process, self-exciting process, Early Warning System

JEL Classification: C13, C15, C53, G17

Suggested Citation

Gresnigt, Francine and Kole, Erik and Franses, Philip Hans, Interpreting Financial Market Crashes as Earthquakes: A New Early Warning System for Medium Term Crashes (June 1, 2014). Tinbergen Institute Discussion Paper 14-067/III, Available at SSRN: https://ssrn.com/abstract=2469697 or http://dx.doi.org/10.2139/ssrn.2469697

Francine Gresnigt (Contact Author)

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

Erik Kole

Erasmus University Rotterdam - Erasmus School of Economics - Econometric Institute ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands
+31 10 408 12 58 (Phone)

HOME PAGE: http://people.few.eur.nl/kole

ERIM

P.O. Box 1738
3000 DR Rotterdam
Netherlands

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

HOME PAGE: http://people.few.eur.nl/kole

Philip Hans Franses

Erasmus University Rotterdam (EUR) - Department of Econometrics ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands
+31 10 408 1278 (Phone)
+31 10 408 9162 (Fax)

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