A Bayesian Covariance Graph and Latent Position Model for Multivariate Financial Time Series

Abstract

Current understanding holds that financial contagion is driven mainly by system-wide interconnectedness of institutions. A distinction has been made between systematic and idiosyncratic channels of contagion, with shocks transmitted through the latter expected to be substantially more likely to lead to a crisis than through the former. Idiosyncratic connectivity is thought to be driven not simply by obviously shared characteristics among institutions, but more by the latent strategic position of firms in financial markets. We propose a Bayesian hierarchical model for multivariate financial time series that characterizes the interdependence in the idiosyncratic factors of a VAR model via a covariance graphical model whose structure is modeled through a latent position model. We develop an efficient algorithm that samples the network of the idiosyncratic factors and the latent positions underlying the network. We examine the dynamic volatility network and latent positions among 150 publicly listed institutions across the United States and Europe and how they contribute to systemic vulnerabilities and risk transmission.

Keywords: Bayesian inference, Covariance graph model, Idiosyncratic Contagion Channels, Latent Space Models, Systemic Risk, VAR

JEL Classification: C55, C51, C52, C62