# Universal and non-universal properties of cross-correlations in financial time series

## Abstract

We use methods of random matrix theory to analyze the cross-correlation matrix C of price changes of the largest 1000 US stocks for the 2-year period 1994-95. We find that the statistics of most of the eigenvalues in the spectrum of C agree with the predictions of random matrix theory, but there are deviations for a few of the largest eigenvalues. We find that C has the universal properties of the Gaussian orthogonal ensemble of random matrices. Furthermore, we analyze the eigenvectors of C through their inverse participation ratio and find eigenvectors with large inverse participation ratios at both edges of the eigenvalue spectrum—a situation reminiscent of results in localization theory.

There has been much recent work applying physics concepts and methods to the study of financial time series . In particular, the study of correlations between price changes of different stocks is both of scientific interest and of practical relevance in quantifying the risk of a given stock portfolio . Consider, for example, the equal-time correlation of stock price changes for a given pair of companies. Since the market conditions may not be stationary, and the historical records are finite, it is not clear if a measured correlation of price changes of two stocks is just due to “noise” or genuinely arises from the interactions among the two companies. Moreover, unlike most physical systems, there is no “algorithm” to calculate the “interaction strength” between two companies (as there is for, say, two spins in a magnet). The problem is that although every pair of companies should interact either directly or indirectly, the precise nature of interaction is unknown.

In some ways, the problem of interpreting the correlations between individual stock-price changes is reminiscent of the difficulties experienced by physicists in the fifties, in interpreting the spectra of complex nuclei. Large amounts of spectroscopic data on the energy levels were becoming available but were too complex to be explained by model calculations because the exact nature of the interactions were unknown. Random matrix theory (RMT) was developed in this context, to deal with the statistics of energy levels of complex quantum systems. With the minimal assumption of a random Hamiltonian, given by a real symmetric matrix with independent random elements, a series of remarkable predictions were made and successfully tested on the spectra of complex nuclei . RMT predictions represent an average over all possible interactions . Deviations from the universal predictions of RMT identify system-specific, non-random properties of the system under consideration, providing clues about the nature of the underlying interactions .

In this letter, we apply RMT methods to study the cross-correlations  of stock price changes. First, we demonstrate the validity of the universal predictions of RMT for the eigenvalue statistics of the cross-correlation matrix. Second, we calculate the deviations of the empirical data from the RMT predictions, obtaining information that enables us to identify cross-correlations between stocks not explainable purely by randomness.

We analyze a data base  containing the price $`S_i(t)`$ of stock $`i`$ at time $`t`$, where $`i=1,\mathrm{},1000`$ denotes the largest 1000 publicly-traded companies and the time $`t`$ runs over the 2-year period 1994-95. From this time series, we calculate the price change $`G_i(t,\mathrm{\Delta }t)`$, defined as

$$G_i(t,\mathrm{\Delta }t)\mathrm{ln}S_i(t+\mathrm{\Delta }t)\mathrm{ln}S_i(t),$$
(1)   
where $`\mathrm{\Delta }t=30`$ min is the sampling time scale. The simplest measure of correlations between different stocks is the equal-time cross-correlation matrix C which has elements

$$C_{ij}\frac{G_iG_jG_iG_j}{\sigma _i\sigma _j},$$
(2)   
where $`\sigma _i\sqrt{G_i^2G_i^2}`$ is the standard deviation of the price changes of company $`i`$, and $`\mathrm{}`$ denotes a time average over the period studied.

We analyze the statistical properties of C by applying RMT techniques. First, we diagonalize C and obtain its eigenvalues $`\lambda _k`$ —with $`k=1,\mathrm{},1000`$—which we rank-order from the smallest to the largest. Next, we calculate the eigenvalue distribution  and compare it with recent analytical results for a cross-correlation matrix generated from finite uncorrelated time series . Figure 1 shows the eigenvalue distribution of C, which deviates from the predictions of Ref. , for large eigenvalues $`\lambda _k1.94`$ (see caption of Fig. 1). This result is in agreement with the results of Ref.  for the eigenvalue distribution of C on a daily time scale.

To test for universal properties, we first calculate the distribution of the nearest-neighbor spacings $`s\lambda _{k+1}\lambda _k`$. The nearest-neighbor spacing is computed after transforming the eigenvalues in such a way that their distribution becomes uniform—a procedure known as unfolding. Figure 2(a) shows the distribution of nearest-neighbor spacings for the empirical data, and compares it with the RMT predictions for real symmetric random matrices. This class of matrices shares universal properties with the ensemble of matrices whose elements are distributed according to a Gaussian probability measure—the Gaussian orthogonal ensemble (GOE). We find good agreement between the empirical data and the GOE prediction,

$$P_{\mathrm{GOE}}(s)=\frac{\pi s}{2}\mathrm{exp}\left(\frac{\pi }{4}s^2\right).$$
(3)   
A second independent test of the GOE is the distribution of next-nearest-neighbor spacings between the rank-ordered eigenvalues . This distribution is expected to be identical to the distribution of nearest-neighbor spacings of the Gaussian symplectic ensemble (GSE) as verified by the empirical data \[Fig. 2(b)\].

The distribution of eigenvalue spacings reflects correlations only of consecutive eigenvalues but does not contain information about correlations of longer range. To probe any “long-range” correlations, we first calculate the number variance $`\mathrm{\Sigma }^2`$ which is defined as the variance of the number of unfolded eigenvalues in intervals of length $`L`$ around each of the eigenvalues. If the eigenvalues are uncorrelated, $`\mathrm{\Sigma }^2L`$. For the opposite case of a “rigid” eigenvalue spectrum, $`\mathrm{\Sigma }^2`$ is a constant. For the GOE case, we find the “intermediate” behavior $`\mathrm{\Sigma }^2\mathrm{ln}L`$, as predicted by RMT \[Fig. 2(c)\].

A second way to measure “long-range” correlations in the eigenvalues is through the spectral rigidity $`\mathrm{\Delta }`$, defined to be the least square deviation of the unfolded cumulative eigenvalue density from a fit to a straight line in an interval of length $`L`$. For uncorrelated eigenvalues, $`\mathrm{\Delta }L`$, whereas for the rigid case $`\mathrm{\Delta }`$ is a constant. For the GOE case we find $`\mathrm{\Delta }\mathrm{ln}L`$ as predicted by RMT \[Fig. 2(d)\].

Having demonstrated that the eigenvalue statistics of C satisfies the RMT predictions, we now proceed to analyze the eigenvectors of C. RMT predicts that the components of the normalized eigenvectors of a GOE matrix are distributed according to a Gaussian probability distribution with mean zero and variance one. In agreement with recent results , we find that eigenvectors corresponding to most eigenvalues in the “bulk” ($`\lambda _k2`$) follow this prediction. On the other hand, eigenvectors with eigenvalues outside the bulk ($`\lambda _k2`$) show marked deviations from the Gaussian distribution. In particular, the vector corresponding to the largest eigenvalue $`\lambda _{1000}`$ deviates significantly from the Gaussian distribution predicted by RMT.

The component $`\mathrm{}`$ of a given eigenvector relates to the contribution of company $`\mathrm{}`$ to that eigenvector. Hence, the distribution of the components contains information about the number of companies contributing to a specific eigenvector. In order to distinguish between one eigenvector with approximately equal components and another with a small number of large components we define the inverse participation ratio 

$$I_k\underset{\mathrm{}=1}{\overset{1000}{}}[u_k\mathrm{}]^4,$$
(4)   
where $`u_k\mathrm{}`$, $`\mathrm{}=1,\mathrm{},1000`$ are the components of eigenvector $`k`$. The physical meaning of $`I_k`$ can be illustrated by two limiting cases: (i) a vector with identical components $`u_k\mathrm{}1/\sqrt{N}`$ has $`I_k=1/N`$, whereas (ii) a vector with one component $`u_{k1}=1`$ and all the others zero has $`I_k=1`$. Therefore, $`I_k`$ is related to the reciprocal of the number of vector components significantly different from zero.

Figure 3 shows $`I_k`$ for eigenvectors of a matrix generated from uncorrelated time series with a power law distribution of price changes. The average value of $`I_k`$ is $`I3\times 10^31/N`$ indicating that the vectors are extended —i.e., almost all companies contribute to them. Fluctuations around this average value are confined to a narrow range. On the other hand, the empirical data show deviations of $`I_k`$ from $`I`$ for a few of the largest eigenvalues. These $`I_k`$ values are approximately 4-5 times larger than $`I`$ which suggests that there are groups of approximately 50 companies contributing to these eigenvectors. The corresponding eigenvalues are well outside the bulk, suggesting that these companies are correlated .

Surprisingly, we also find that there are $`I_k`$ values as large as $`0.35`$ for vectors corresponding to the smallest eigenvalues $`\lambda _i0.25`$ . These deviations from the average are two orders of magnitude larger than $`I`$, which suggests that the vectors are localized —i.e., only a few companies contribute to them. The small values of the corresponding eigenvalues suggests that these companies are uncorrelated with each other.

The presence of vectors with large $`I_k`$ also arises in the theory of Anderson localization. In the context of localization theory, one frequently finds “random band matrices” containing extended states with small $`I_k`$ in the middle of the band, whereas edge states are localized and have large $`I_k`$. Our finding of localized states for small and large eigenvalues of the cross-correlation matrix C is reminiscent of Anderson localization and suggests that C may be a random band matrix

In summary, we find that the most eigenvalues in the spectrum of the cross-correlation matrix of stock price changes agree surprisingly well with the universal predictions of random matrix theory. In particular, we find that C satisfies the universal properties of the Gaussian orthogonal ensemble of real symmetric random matrices. We find through the analysis of the inverse participation ratio of its eigenvectors that C may be a random band matrix, which may support the idea that a metric can be defined on the space of companies and that a distance can be defined between pairs of companies. Hypothetically, the presence of localized states may allow us to draw conclusions about the “spatial dimension” of the set of stocks studied here and about the “range” of the correlations between the companies.

We thank M. Barthélémy, N.V. Dohkolyan, X. Gabaix, U. Gerland, S. Havlin, R.N. Mantegna, Y. Lee, C.-K.-Peng and D. Stauffer for helpful discussions. LANA thanks FCT/Portugal for financial support. The Center for Polymer Studies is supported by NSF.