Unraveling S&P500 stock volatility and networks -- An encoding-and-decoding approach

Abstract

Volatility of financial stock is referring to the degree of uncertainty or risk embedded within a stock's dynamics. Such risk has been received huge amounts of attention from diverse financial researchers. By following the concept of regime-switching model, we proposed a non-parametric approach, named encoding-and-decoding, to discover multiple volatility states embedded within a discrete time series of stock returns. The encoding is performed across the entire span of temporal time points for relatively extreme events with respect to a chosen quantile-based threshold. As such the return time series is transformed into Bernoulli-variable processes. In the decoding phase, we computationally seek for locations of change points via estimations based on a new searching algorithm in conjunction with the information criterion applied on the observed collection of recurrence times upon the binary process. Besides the independence required for building the Geometric distributional likelihood function, the proposed approach can functionally partition the entire return time series into a collection of homogeneous segments without any assumptions of dynamic structure and underlying distributions. In the numerical experiments, our approach is found favorably compared with parametric models like Hidden Markov Model. In the real data applications, we introduce the application of our approach in forecasting stock returns. Finally, volatility dynamic of every single stock of S&P500 is revealed, and a stock network is consequently established to represent dependency relations derived through concurrent volatility states among S&P500.