Introducing a Scale of Market Shocks

Abstract

We introduce two event scales for financial markets, called scale of market shocks (SMS), which measure the importance of the market movements. These indices are based on the price volatility and are computed by integrating mapped asset volatilities over time horizons that range from 1 hour to 42 days. The first SMS is an absolute scale, or universal scale, allowing values of different assets to be compared directly. The second SMS is an adaptive scale, calibrated to the typical behavior of each asset, allowing the relative importance of market movements to be assessed. In principle, the SMS can be constructed for any market: the indices are computed from the price time series. In the foreign exchange (FX) market, each index is associated with a currency pair and we derive from it an index per currency and an index for the whole market. In order to define the most appropriate SMS, the probability distribution for the volatilities is studied first. Then, the probability distribution of the two scales is computed. For USD/DEM and USD/JPY, the relations between peaks for the SMS and major world events is put forward. In addition, we also measure the correlation between the Scale of Market Shocks index and the size of the next price movements, which shows a high correlation for short time intervals.