Changes in Cross-Correlations as an Indicator for Systemic Risk

Abstract

The 2008–2012 global financial crisis began with the global recession in December 2007 and exacerbated in September 2008, during which the U.S. stock markets lost 20% of value from its October 11 2007 peak. Various studies reported that financial crisis are associated with increase in both cross-correlations among stocks and stock indices and the level of systemic risk. In this paper, we study 10 different Dow Jones economic sector indexes, and applying principle component analysis (PCA) we demonstrate that the rate of increase in principle components with short 12-month time windows can be effectively used as an indicator of systemic risk—the larger the change of PC1, the higher the increase of systemic risk. Clearly, the higher the level of systemic risk, the more likely a financial crisis would occur in the near future.