Information transmission a good predictor of credit crisis

May 31, 2013

The recent credit crisis was preceded by a sharp increase in the transmission of information in the largest derivatives market. Such transmissions can therefore serve as indicators for the instability of the market. A team of researchers from the University of Amsterdam (UvA) and the Dutch ING Bank discovered this unexpected link and have published their findings in the leading online journal Scientific Reports, from the publishers of Nature.

The financial swap is a large network of risk swaps between banks and pension funds, whereby each swap 'exchanges' risk between two players. Each player seeks to minimise the risk in his own portfolio by engaging in interest rate swaps with other players. Over time, however, this practice can lead to the entire market becoming an unstable network, in which one small shock can trigger a critical situation. Because no single party has a complete overview of this network, the build-up of instability goes undetected. The recent credit crisis came as a surprise, but the findings from the UvA and ING study may be used to generate a useful early for possible new crises in the future.

Growing dependence

UvA researcher Dr Rick Quax and his colleagues Prof. Peter Sloot (UvA) and Dr Drona Kandhai ( and ING) explain their discovery: 'In mathematical terms, a build-up of instability in a network leads to an increase in information transmissions. But because the financial swap network is hidden, we can't immediately compute these transmissions. As it turns out, we found a solution in the structure of the swap itself. Basically, a growing interdependence between banks causes a growing interdependence between swap interest rates with varying maturities. Consequently, information transmissions in the financial network also cause information transmissions between interest rate levels. As this data is publicly available, we were able to measure the build-up of instability after all.'

Early warning system

The researchers applied their analysis to the levels of the Euro and Dollar markets over the past 12 years. The resulting data provided the first clear picture of how years of accumulated instability on the dollar market suddenly overflowed into the euro market roughly three months before the struck. In both markets, the onset of the current crisis (the bankruptcy of Lehman Brothers in September 2008) was preceded by a sharp increase in this instability. Quax, Kandhai and Sloot have demonstrated that this increase could have been used to provide an automatic three to six months before the actual collapse.

The introduction of such an early warning signal could actually bolster the robustness of the financial market. Since an increase in information transmission would indicate a heightened possibility of a crisis, banks and would be able to adjust their behaviour accordingly, for example by trading risks in a different format until the warning signal dies out.

Given that networks are a common phenomenon in nature – from molecular protein networks all the way up to social networks – the results of this study could also help to provide a better understanding of robustness and the cause of sudden changes in a wide range of complex systems, both natural and man-made.

Explore further: Research finds Australian dollar not safe haven in European Crisis

More information: Quax, R., Kandhai, D. and Sloot, P. Information dissipation as an early-warning signal for the Lehman Brothers collapse in financial time series, in: Scientific Reports, 30 May 2013. www.nature.com/srep/2013/130530/srep01898/full/srep01898.html

add to favorites email to friend print save as pdf

Related Stories

Public firms weathered recession better than expected

Jun 20, 2011

(PhysOrg.com) -- The prevailing narrative of the financial crisis revolves around banks' reduced ability to issue loans, but a new paper by University of Arizona associate professor of finance Kathy Kahle reveals that the ...

Storm warning: Financial tsunami heading this way

Feb 09, 2012

In today's global village, national coffers are more interconnected than ever before. And as the current economic crisis has proven, a downturn in one country can travel in a wave across the globe, like a financial tsunami. ...

Recommended for you

Which foods may cost you more due to Calif. drought

Apr 17, 2014

With California experiencing one of its worst droughts on record, grocery shoppers across the country can expect to see a short supply of certain fruits and vegetables in stores, and to pay higher prices ...

Performance measures for CEOs vary greatly, study finds

Apr 16, 2014

As companies file their annual proxy statements with the U.S. Securities and Exchange Commission (SEC) this spring, a new study by Rice University and Cornell University shows just how S&P 500 companies have ...

User comments : 0

More news stories

Male-biased tweeting

Today women take an active part in public life. Without a doubt, they also converse with other women. In fact, they even talk to each other about other things besides men. As banal as it sounds, this is far ...

Archaeologists, tribe clash over Native remains

Archaeologists and Native Americans are clashing over Indian remains and artifacts that were excavated during a construction project in the San Francisco Bay Area, but then reburied at an undisclosed location.

Math modeling handbook now available

Math comes in handy for answering questions about a variety of topics, from calculating the cost-effectiveness of fuel sources and determining the best regions to build high-speed rail to predicting the spread ...

Cyber buddy is better than 'no buddy'

A Michigan State University researcher is looking to give exercise enthusiasts the extra nudge they need during a workout, and her latest research shows that a cyber buddy can help.