A Liquidity-Based Stock Network
36 Pages Posted: 23 Nov 2016 Last revised: 30 Jan 2017
Date Written: November 23, 2016
Stocks are connected through common ownership of financial institutions. Firm shocks can be transmitted and amplified through these interconnections, aggregating into market level fluctuations. We formalize this intuition by estimating a parsimonious model using mutual fund holding data. The model allows us to quantify the aggregate outcome of propagation of firm level shocks through the network. Using earnings surprises as a proxy for firm shocks, we find that our model's aggregation is significantly correlated with the aggregate market return. Also, the network structure estimated by our model can predict subsequent volatility of aggregate market returns and forecast the volatility of and correlation between individual stocks' future returns.
Keywords: network, systemic risk, amplification mechanism, liquidity shock, mutual fund
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