Events and Meetings of Italian Statistical Society, Statistics and Demography: the Legacy of Corrado Gini

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Networks, pricing and diversification
Massimiliano Caporin, Monica Billio, Loriana Pelizzon, Roberto Panzica

Last modified: 2015-09-05

Abstract


The need for understanding the propagation mechanisms behind the recent financial crises lead the increased interest for works associated with asset interconnections. In this framework, network-based methods have been used to infer from data the linkages between institutions. In this paper, we elaborate on this and make a step forward by introducing network linkages into linear factor models. Networks are used to infer the exogenous and contemporaneous links across assets, and impacts on several dimensions: network exposures act as inflating factor for systematic exposure to common factors with implications for pricing; the power of diversification is reduced by the presence of network connections; in the presence of network links a misspecified traditional linear factor model provides residuals that are correlated and heteroskedastic. We support our claims with an extensive simulation experiment.

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