Nonlinear dynamics and recurrence plots for detecting financial crisis

Abstract

Identification of financial bubbles and crisis is a topic of major concern since it is important to prevent collapses that can severely impact nations and economies. Our analysis deals with the use of the recently proposed ⿿delay vector variance⿿ (DVV) method, which examines local predictability of a signal in the phase space to detect the presence of determinism and nonlinearity in a time series. Optimal embedding parameters used in the DVV analysis are obtained via a differential entropy based method using wavelet-based surrogates. We exploit the concept of recurrence plots to study the stock market to locate hidden patterns, non-stationarity, and to examine the nature of these plots in events of financial crisis. In particular, the recurrence plots are employed to detect and characterize financial cycles. A comprehensive analysis of the feasibility of this approach is provided. We show that our methodology is useful in the diagnosis and detection of financial bubbles, which have significantly impacted economic upheavals in the past few decades.