We apply the knockoff procedure to factor selection in finance. By building fake but realistic factors, this procedure makes it possible to control the fraction of false discovery in a given set of factors. To show its versatility, we apply it to fund replication and to the inference of explanatory and prediction networks.
Network theory proved recently to be useful in the quantification of many properties of financial systems. The analysis of the structure of investment portfolios is a major application since their eventual correlation and overlap impact the actual ri
sk diversification by individual investors. We investigate the bipartite network of US mutual fund portfolios and their assets. We follow its evolution during the Global Financial Crisis and analyse the interplay between diversification, as understood in classical portfolio theory, and similarity of the investments of different funds. We show that, on average, portfolios have become more diversified and less similar during the crisis. However, we also find that large overlap is far more likely than expected from models of random allocation of investments. This indicates the existence of strong correlations between fund portfolio strategies. We introduce a simplified model of propagation of financial shocks, that we exploit to show that a systemic risk component origins from the similarity of portfolios. The network is still vulnerable after crisis because of this effect, despite the increase in the diversification of portfolios. Our results indicate that diversification may even increase systemic risk when funds diversify in the same way. Diversification and similarity can play antagonistic roles and the trade-off between the two should be taken into account to properly assess systemic risk.
The stock market has been known to form homogeneous stock groups with a higher correlation among different stocks according to common economic factors that influence individual stocks. We investigate the role of common economic factors in the market
in the formation of stock networks, using the arbitrage pricing model reflecting essential properties of common economic factors. We find that the degree of consistency between real and model stock networks increases as additional common economic factors are incorporated into our model. Furthermore, we find that individual stocks with a large number of links to other stocks in a network are more highly correlated with common economic factors than those with a small number of links. This suggests that common economic factors in the stock market can be understood in terms of deterministic factors.
Based on the daily data of American and Chinese stock markets, the dynamic behavior of a financial network with static and dynamic thresholds is investigated. Compared with the static threshold, the dynamic threshold suppresses the large fluctuation
induced by the cross-correlation of individual stock prices, and leads to a stable topological structure in the dynamic evolution. Long-range time-correlations are revealed for the average clustering coefficient, average degree and cross-correlation of degrees. The dynamic network shows a two-peak behavior in the degree distribution.
We test the hypothesis that interconnections across financial institutions can be explained by a diversification motive. This idea stems from the empirical evidence of the existence of long-term exposures that cannot be explained by a liquidity motiv
e (maturity or currency mismatch). We model endogenous interconnections of heterogenous financial institutions facing regulatory constraints using a maximization of their expected utility. Both theoretical and simulation-based results are compared to a stylized genuine financial network. The diversification motive appears to plausibly explain interconnections among key players. Using our model, the impact of regulation on interconnections between banks -currently discussed at the Basel Committee on Banking Supervision- is analyzed.
Is the large influence that mutual funds assert on the U.S. financial system spread across many funds, or is it is concentrated in only a few? We argue that the dominant economic factor that determines this is market efficiency, which dictates that f
und performance is size independent and fund growth is essentially random. The random process is characterized by entry, exit and growth. We present a new time-dependent solution for the standard equations used in the industrial organization literature and show that relaxation to the steady-state solution is extremely slow. Thus, even if these processes were stationary (which they are not), the steady-state solution, which is a very heavy-tailed power law, is not relevant. The distribution is instead well-approximated by a less heavy-tailed log-normal. We perform an empirical analysis of the growth of mutual funds, propose a new, more accurate size-dependent model, and show that it makes a good prediction of the empirically observed size distribution. While mutual funds are in many respects like other firms, market efficiency introduces effects that make their growth process distinctly different. Our work shows that a simple model based on market efficiency provides a good explanation of the concentration of assets, suggesting that other effects, such as transaction costs or the behavioral aspects of investor choice, play a smaller role.