Fractal Markets, Fractional Integration, and Long Memory in Financial Time Series – I

The concepts – ‘fractal market hypothesis,’ ‘fractional integration of time series,’ and ‘long memory and persistence in time series’ – are related in terms of their proponents and history.

I’m going to put up ideas, videos, observations, and analysis relating to these concepts over the next several posts, since, more and more, I think they lead to really fundamental things, which, possibly, have not yet been fully explicated.

And there are all sorts of clear connections with practical business and financial forecasting – for example, if macroeconomic or financial time series have “long memory,” why isn’t this characteristic being exploited in applied forecasting contexts?

And, since it is Friday, here are a couple of relevant videos to start the ball rolling.

Benoit Mandelbrot, maverick mathematician and discoverer of ‘fractals,’ stands at the crossroads in the 1970’s, contributing or suggesting many of the concepts still being intensively researched.

In economics, business, and finance, the self-similarity at all scales idea is trimmed in various ways, since none of the relevant time series are infinitely divisible.

A lot of energy has gone into following Mandelbrot suggestions on the estimation of Hurst exponents for stock market returns.

This YouTube by a Parallax Financial in Redmond, WA gives you a good flavor of how Hurst exponents are being used in technical analysis. Later, I will put up materials on the econometrics involved.

Blog posts are a really good way to get into this material, by the way. There is a kind of formalism – such as all the stuff in time series about backward shift operators and conventional Box-Jenkins – which is necessary to get into the discussion. And the analytics are by no means standardized yet.

An Update on Bitcoin

Fairly hum-drum days of articles on testing for unit roots in time series led to discovery of an extraordinary new forecasting approach – using the future to predict the present.

Since virtually the only empirical application of the new technique is predicting bubbles in Bitcoin values, I include some of the recent news about Bitcoins at the end of the post.

Noncausal Autoregressive Models

I think you have to describe the forecasting approach recently considered by Lanne and Saikkonen, as well as Hencic, Gouriéroux and others, as “exciting,” even “sexy” in a Saturday Night Live sort of way.

Here is a brief description from a 2015 article in the Econometrics of Risk called Noncausal Autoregressive Model in Application to Bitcoin/USD Exchange Rates

noncausal

I’ve always been a little behind the curve on lag operators, but basically Ψ(L-1) is a function of the standard lagged operators, while Φ(L) is a second function of offsets to future time periods.

To give an example, consider,

yt = k1yt-1+s1yt+1 + et

where subscripts t indicate time period.

In other words, the current value of the variable y is related to its immediately past value, and also to its future value, with an error term e being included.

This is what I mean by the future being used to predict the present.

Ordinarily in forecasting, one would consider such models rather fruitless. After all, you are trying to forecast y for period t+1, so how can you include this variable in the drivers for the forecasting setup?

But the surprising thing is that it is possible to estimate a relationship like this on historic data, and then take the estimated parameters and develop simulations which lead to predictions at the event horizon, of, say, the next period’s value of y.

This is explained in the paragraph following the one cited above –

noncausal2

In other words, because et in equation (1) can have infinite variance, it is definitely not normally distributed, or distributed according to a Gaussian probability distribution.

This is fascinating, since many financial time series are associated with nonGaussian error generating processes – distributions with fat tails that often are platykurtotic.

I recommend the Hencic and Gouriéroux article as a good read, as well as interesting analytics.

The authors proposed that a stationary time series is overlaid by explosive speculative periods, and that something can be abstracted in common from the structure of these speculative excesses.

Mt. Gox, of course, mentioned in this article, was raided in 2013 by Japanese authorities, after losses of more than $465 million from Bitcoin holders.

Now, two years later, the financial industry is showing increasing interest in the underlying Bitcoin technology and Bitcoin prices are on the rise once again.

bitcoin

Anyway, the bottom line is that I really, really like a forecast methodology based on recognition that data come from nonGaussian processes, and am intrigued by the fact that the ability to forecast with noncausal AR models depends on the error process being nonGaussian.

Coming Attractions

Well, I have been doing a deep dive into financial modeling, but I want to get back to blogging more often. It gets in your blood, and really helps explore complex ideas.

So- one coming attraction here is going to be deeper discussion of the fractal market hypothesis.

Ladislav Kristoufek writes in a fascinating analysis (Fractal Markets Hypothesis and the Global Financial Crisis:Scaling, Investment Horizons and Liquidity) that,

“..it is known that capital markets comprise of various investors with very different investment horizons { from algorithmically-based market makers with the investment horizon of fractions of a second, through noise traders with the horizon of several minutes, technical traders with the horizons of days and weeks, and fundamental analysts with the monthly horizons to pension funds with the horizons of several years. For each of these groups, the information has different value and is treated variously. Moreover, each group has its own trading rules and strategies, while for one group the information can mean severe losses, for the other, it can be taken a profitable opportunity.”

The mathematician and discoverer of fractals Mandelbrot and investor Peters started the ball rolling, but the idea maybe seemed like a fad of the 1980’s and 1990s.

But, more and more,  new work in this area (as well as my personal research) points to the fact that the fractal market hypothesis is vitally important.

Forget chaos theory, but do notice the power laws.

The latest  fractal market research is rich in mathematics – especially wavelets, which figure in forecasting, but which I have not spent much time discussing here.

There is some beautiful stuff produced in connection with wavelet analysis.

For example, here is a construction from a wavelet analysis of the NASDAQ from another paper by Kristoufek

Wavlet1

The idea is that around 2008, for example, investing horizons collapsed, with long term traders exiting and trading becoming more and more short term. This is associated with problems of liquidity – a concept in the fractal market hypothesis, but almost completely absent from many versions of the so-called “efficient market hypothesis.”

Now, maybe like some physicists, I am open to the discovery of deep keys to phenomena which open doors of interpretation across broad areas of life.

Another coming attraction will be further discussion of forward information on turning points in markets and the business cycle generally.

The current economic expansion is growing long in tooth, pushing towards the upper historically observed lengths of business expansions in the United States.

The basic facts are there for anyone to notice, and almost sound like a litany of complaints about how the last crisis in 2008-2009 was mishandled. But China is decelerating, and the emerging economies do not seem positioned to make up the global growth gap, as in 2008-2009. Interest rates still bounce along the zero bound. With signs of deteriorating markets and employment conditions, the Fed may never find the right time to raise short term rates – or if they plunge ahead will garner virulent outcry. Financial institutions are even larger and more concentrated now than before 2008, so “too big to fail” can be a future theme again.

What is the best panel of financial and macroeconomic data to watch the developments in the business cycle now?

So those are a couple of topics to be discussed in posts here in the future.

And, of course, politics, including geopolitics will probably intervene at various points.

Initially, I started this blog to explore issues I encountered in real-time business forecasting.

But I have wide-ranging interests – being more of a fox than a hedgehog in terms of Nate Silver’s intellectual classification.

I’m a hybrid in terms of my skill set. I’m seriously interested in mathematics and things mathematical. I maybe have a knack for picking through long mathematical arguments to grab the key points. I had a moment of apparent prodigy late in my undergrad college career, when I took graduate math courses and got straight A’s and even A+ scores on final exams and the like.

Mathematics is time consuming, and I’ve broadened my interests into economics and global developments, working around 2002-2005 partly in China.

As a trivia note,  my parents were immigrants to the US from Great Britain , where their families were in some respects connected to the British Empire that more or less vanished after World War II and, in my father’s case, to the Bank of England. But I grew up in what is known as “the West” (Colorado, not California, interestingly), where I became a sort of British cowboy and subsequently, hopefully, have continued to mature in terms of attitudes and understanding.