Equity Market Description under High and Low Volatility Regimes Using Maximum Entropy Pairwise Distribution

The financial market is a complex system in which the assets influence each other, causing, among other factors, price interactions and co-movement of returns. Using the Maximum Entropy Principle approach, we analyze the interactions between a selected set of stock assets and equity indices under different high and low return volatility episodes at the 2008 Subprime Crisis and the 2020 COVID-19 outbreak. We carry out an inference process to identify the interactions, in which we implement the a pairwise Ising distribution model describing the first and second moments of the distribution of the discretized returns of each asset. Our results indicate that second-order interactions explain more than 80% of the entropy in the system during the Subprime Crisis and slightly higher than 50% during the COVID-19 outbreak independently of the period of high or low volatility analyzed. The evidence shows that during these periods, slight changes in the second-order interactions are enough to induce large changes in assets correlations but the proportion of positive and negative interactions remains virtually unchanged. Although some interactions change signs, the proportion of these changes are the same period to period, which keeps the system in a ferromagnetic state. These results are similar even when analyzing triadic structures in the signed network of couplings.

Automated summary

Using the Maximum Entropy Principle approach, interactions between a selected set of stock assets and equity indices under different high and low return volatility episodes were analyzed. Second-order interactions were found to play a significant role in explaining the system entropy during the Subprime Crisis and the COVID-19 outbreak, with slight changes in these interactions leading to large changes in assets correlations. Despite some changes in interactions, the proportion of positive and negative interactions remained largely unchanged, maintaining the system in a ferromagnetic state.