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February 7, 2014 Quantitative Finance khvhs04Feb14
To appear in Quantitative Finance, Vol. 00, No. 00, Month 20XX, 115
Partial correlation analysis:
Applications for nancial markets
Dror Y. Kenett

, Xuqing Huang

, Irena Vodenska ,
Shlomo Havlin and H. Eugene Stanley
Center for Polymer Studies and Department of Physics,
Boston University, Boston, MA 02215 USA
Administrative Sciences Department, Metropolitan College,
Boston University, Boston MA 02215 USA
Department of Physics,
Bar-Ilan University, Ramat-Gan 52900 Israel
(February 7, 2014)
The presence of signicant cross-correlations between the synchronous time evolution of a pair of
equity returns is a well-known empirical fact. The Pearson correlation is commonly used to indicate
the level of similarity in the price changes for a given pair of stocks, but it does not measure whether
other stocks inuence the relationship between them. To explore the inuence of a third stock on the
relationship between two stocks, we use a partial correlation measurement to determine the underlying
relationships between nancial assets. Building on previous work, we present a statistically robust
approach to extract the underlying relationships between stocks from four dierent nancial markets:
the United States, the United Kingdom, Japan, and India. This methodology provides new insights into
nancial market dynamics and uncovers implicit inuences in play between stocks. To demonstrate the
capabilities of this methodology, we (i) quantify the inuence of dierent companies and, by studying
market similarity across time, present new insights into market structure and market stability, and (ii)
we present a practical application, which provides information on the how a company is inuenced by
dierent economic sectors, and how the sectors interact with each other. These examples demonstrate
the eectiveness of this methodology in uncovering information valuable for a range of individuals,
including not only investors and traders but also regulators and policy makers.
Keywords: Financial markets; Partial correlations; Inuence; Risk
JEL Classication: G10, C10, D40

These authors had equal contribution. Corresponding author email: drorkenett@gmail.com

These authors had equal contribution. Corresponding author email: eqing2700@gmail.com

1
February 7, 2014 Quantitative Finance khvhs04Feb14
1. Introduction
Understanding the complex nature of nancial markets remains a great challenge, especially
in light of the most recent crisis of 2008. Recent studies have investigated large data sets of
nancial markets, and have analyzed and modeled the static and dynamic behavior of this very
complex system (Fama 1965, Lo et al. 1997, Lo and Craig MacKinlay 1990, Brock et al. 2009,
Cont and Bouchaud 2000, Eisler and Kertesz 2006, Lux et al. 1999, Bouchaud and Potters 2003,
Voit 2005, Sinha et al. 2010, Abergel et al. 2011, Takayasu 2006, Sornette 2004), suggesting that
nancial markets exhibit systemic shifts and display non-equilibrium properties.
One prominent feature in nancial markets is the presence of an observed correlation (positive
or negative) between the price movements of dierent nancial assets. The presence of a high
degree of cross-correlation between the synchronous time evolution of a set of equity returns
is a well known empirical fact (Markowitz 1952, Elton et al. 2009, Campbell et al. 1997). The
Pearson correlation coecient (Pearson 1895) provides information about the similarity in the
price change behavior of a given pair of stocks. Much eort has been devoted to extracting
meaningful information from the observed correlations in order to gain insights into the un-
derlying structure and dynamics of nancial markets (Embrechts et al. 2002, Morck et al. 2000,
Campbell et al. 2008, Krishan et al. 2009, Aste et al. 2010, Campbell et al. 2008, Cizeau et al.
2001, Laloux et al. 2000, 1999, Plerou et al. 1999, Podobnik et al. 2009, Pollet and Wilson 2010,
Tumminello et al. 2010, Huang et al. 2013, Forbes and Rigobon 2002).
A large body of work has dealt with the systemic risks introduced into a nancial system when
there is a co-movement of nancial assets. To understand how risks propagate through the entire
system, many studies have focused on understanding the synchronization in nancial markets
that is especially pronounced during periods of crisis (Haldane and May 2011, Bisias et al. 2012).
Recent advancements include the CoVaR methodology (Adrian and Brunnermeier 2011), and
and Granger causality analysis (Granger 1969, Billio et al. 2012). These measures focus on the
relationship of one variable on a second variable, for a given time period. Finally, much work has
been focused on the issue of conditional correlation (Engle 2002) and event conditional correlation
(Maugis 2014), and its applications in nancial markets. However, a missing dimension of these
methodologies is the investigation of many-body interaction between nancial assets.
Despite the meaningful information provided by investigating the correlation coecient, it
lacks the capacity to provide information about whether a dierent stock(s) eventually controls
the observed relationship between other stocks. To overcome this issue we introduce the use of
the partial correlation coecient (Baba et al. 2004), and its applications.
A partial (or residual) correlation measures how much a a given variable, say j, aects the
correlations between another pair of variables, say i and k. Thus, in this (i, k) pair, the partial
correlation value indicates the correlation remaining between i and k after the correlation be-
tween i and j and between k and j have been subtracted. Dened in this way, the dierence
between the correlations and the partial correlations provides a measure of the inuence of vari-
able j on the correlation (i, k). Therefore, we dene the inuence of variable j on variable i, or
the dependency of variable i on variable j, as D(i, j), to be the sum of the inuence of variable
j on the correlations of variable i with all other variables. This methodology has originally been
introduced for the study of nancial data (Kenett et al. 2010, 2012a,b, Maugis 2014), it has
been extended and applied to other systems, such as the immune system (Madi et al. 2011),
and semantic networks (Kenett et al. 2011). Causality, and more specically the nature of the
correlation relationships between dierent stocks, is a critical issue to unveil. The main goal of
our study is to understand the underlying mechanisms of inuence that are present in nancial
markets.
Previous work has focused on how variable j aects variable i, by averaging over all (i, k)
pairs, thus quantifying how variable j aects the average correlation of i with all other variables.
Although this has provided important information that has been both investigated and statisti-
cally validated, our goal here is to present a more general and robust method to statistically pick
2
February 7, 2014 Quantitative Finance khvhs04Feb14
the meaningful links without rst averaging over all pairs. Unlike the previous work in which the
average inuence of j on the correlation of i with all others was calculated, and then statistically
validated, here we rst lter for validated links, and then average the inuence. In order to
achieve this we expand the original methodology and use statistical validation methods to lter
the signicant links. This statistically validated selection process reveals signicant inuence
relationships between dierent nancial assets. This new methodology allows us to quantify the
inuence dierent assets (e.g., economic sectors, other markets, or macro-economic factors) have
on a given asset. The information generated by our methodology is applicable to such areas as
risk management, portfolio optimization, and nancial contagion, and is valuable to both policy
makers and practitioners.
The rest of this paper is organized as follows: In Section 2 we introduce the partial correla-
tion approach to quantify inuence between nancial assets. We present the new extensions of
the methodology, which allows the selection of statistically signicant inuence links between
dierent assets. We further discuss the empirical data analyzed in this study. In Sections 3 and
4 we present two possible applications of the methodology. In Section 3 we focus on how the
methodology provides new insights into market structure and its stability across time, while in
Section 4 we present a practical application, which provides information on the how a company
is inuenced by dierent economic sectors, and how the sectors interact with each other. Finally,
in Section 5 we discuss our results and provide additional insights into possible applications of
this methodology.
2. Quantifying underlying relationships between nancial assets
The aim of this paper is to present a new methodology that sheds new light on the underlying re-
lationships between nancial assets. Building on previous work (Kenett et al. (2010)), we present
a robust and statistically signicant approach to extracting the hidden underlying relationships.
As such, the presented methodology provides new insights into the underlying mechanisms of
nancial markets.
2.1 Data
For the analysis reported in this paper we use daily adjusted closing stock price time series
from four dierent markets, data provided by the Thomson Reuters Datastream. The markets
investigated are the U.S., the U.K., Japan, and India, (see Table 1 for details, also Kenett et al.
(2012b)). We only consider stocks that are active from January 2000 until December 2010.
Volume data was used to identify and eliminate illiquid stocks from the sample. Table 1 presents
the number of stocks remaining after ltering out the stocks that had no price movement for
more than 6 percent of the 2700 trading days.
Table 1. Summary of data sample
Market Stocks used Index used # before # ltered
U.S. S&P 500 S&P 500 500 403
U.K. FTSE 350 FTSE 350 356 116
Japan Nikkei 500 Nikkei 500 500 315
India BSE 200 BSE 100 193 126
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February 7, 2014 Quantitative Finance khvhs04Feb14
2.2 Stock raw and partial correlation
To study the similarity between stock price changes, we calculate the time series of the daily log
return, given by
r
i
(t) = log[P
i
(t)/P
i
(t 1)], (1)
where P
i
(t) is the daily adjusted closing price of stock i at day t. The stock raw correlations are
calculated using the Pearson correlation coecient (Pearson 1895)
(i, j) =
r(i) r(i) r(j) r(j)
(i) (j)
, (2)
where represents average over all days, and (i) denotes the standard deviation.
However, in some cases, a strong correlation not necessarily means strong direct relation
between two variables. For example, two stocks in the same market can be inuenced by common
macroeconomic factors and investor psychological factors. To study the direct correlation of
the performance of these two stocks, we need to remove the common driving factors, which
are represented by the market index. Partial correlation quanties the correlation between two
variables, e.g. stocks returns, when conditioned on one or several other variables (Baba et al.
2004, Shapira et al. 2009, Kenett et al. 2010). Specically, let X, Y be two stock return time
series and M be the index. The partial correlation, (X, Y : M), between variables X and Y
conditioned on variable M is the Pearson correlation coecient between the residuals of X and
Y that are uncorrelated with M. To obtain these residuals of X and Y , they are both regressed
on M. The partial correlation coecient can be expressed in terms of the Pearson correlation
coecients as
(X, Y : M)
(X, Y ) (X, M)(Y, M)
_
[1
2
(X, M)] [1
2
(Y, M)]
. (3)
In gure 1 (a), we plot the correlation and partial correlation (using the index as the condi-
tioning variable) between stocks that belong to the S&P 500 index. The gure shows that all
points are below the diagonal straight line, which means the inuence from the index to the
correlation between any pair of stocks is always positive. Furthermore, when two stocks X and
Y both have business relation with a third common stock Z, their prices can be both aected by
the performance of the third stock, thus showing similar price movements even after removing
the index. By removing the inuence from the third company, we can see the importance of
the role that the third stock acts in the correlation of two stocks. Partial correlation coecient
between X and Y conditioned on both M and Z is
(X, Y : M, Z)
(X, Y : M) (X, Z : M)(Y, Z : M)
_
[1
2
(X, Z : M)] [1
2
(Y, Z : M)]
. (4)
In order to quantify the inuence of stock Z on the pair of X and Y , we focus on the Inuence
quantity
d(X, Y : Z) (X, Y : M) (X, Y : M, Z). (5)
This quantity is large when a signicant fraction of the partial correlation (X, Y : M) can be
explained in terms of Z. In previous research, Kenett et al. dened this quantity by d

(X, Y :
4
February 7, 2014 Quantitative Finance khvhs04Feb14
Z) (X, Y ) (X, Y : Z), which holds for general cases (Kenett et al. 2010). However, for
the stock market case specically, the fraction of (X, Y ) that can be explained by Z contains
two parts, index inuence and stocks Z inuence, because stock Z contains information of the
index. Usually, the inuence from the index is prevailing and overwhelms the inuence from an
individual stocks. For example, when X and Y are competitor and cooperator respectively to
stock Z, performances of X and Y should have negative correlation because of Z. In this case,
the inuence from Z to the correlation between stocks X and Y should be negative. However,
because of the dominant correlation between these two stocks and the index, the d

(X, Y : Z) is
still positive. Thus, we suggest to remove the inuence of the market before studying the inuence
of a stock Z on a pair of stocks. In the scatter plot of the partial correlation conditioned on
index v.s. the partial correlation conditioned on both index and an individual stock (gure 1
(b)), the points distribute at both sides of the diagonal line, meaning a signicant fraction of
d(X, Y : Z) is negative.
(a) (b)
Figure 1. (a) Scatter plot of correlation v.s. partial correlation conditioned on index. It is possible to observe
that all points are below the diagonal straight line, which means the inuence from the index to the correlation
between any pair of stocks is always positive. (b) Scatter plot of partial correlation conditioned on index v.s partial
correlation conditioned on both index and a third stock. It is possible to observe that the points distribute at both
sides of the diagonal line, meaning a signicant fraction of d(X, Y : Z) is negative (mainly for low (X, Y : M)
values). In both gures, X, Y, Z represent return time series of stocks, M represents return time series of S&P 500
index. The red curve is the diagonal straight line.
The average inuence d(X : Z) of stock Z on the correlations between stock X and all the
other stocks in the system is dened as
d(X : Z) d(X, Y : Z)
Y =X
. (6)
It is important to note that d(X : Z) approximates the net inuence from stock Z to stock X,
excluding the inuence from the index.
2.3 Test of statistical signicance
In a system of size N, there exists N(N1)(N2)/2 partial correlation interactions, d(X, Y : Z),
when all information is considered. To simplify the description of the system, the non-trivial
interactions with certain signicance level are selected. To decide the signicance of partial
correlation, we provide two methods: 1) Fishers transformation based approach; and 2) empirical
based approach.
5
February 7, 2014 Quantitative Finance khvhs04Feb14
2.3.1 Fisher transformation statistical signicance test. We rst introduce the
Fishers transformation method. According to ref. (Fisher 1915), when X and Y follow a bi-
variate normal distribution and X(t), Y (t) pairs to form the correlation are independent for
t = 1...n, a transformation of the Pearson correlation
z() =
1
2
ln
_
1 +
1
_
= artanh() (7)
approximately follows normal distribution N(
1
2
ln
_
1+r
1r
_
,
1

N3
), where r is the population cor-
relation coecient and N is the sample size. The Fisher transformation holds when is not too
large and N is not too small. Furthermore, the Fishers z-transform of the partial correlation
coecients approximately follows (Fisher 1924)
_

_
z ((X, Y : M)) N(
1
2
ln
_
1 + r(X, Y : M)
1 r(X, Y : M)
_
,
1

N 3
)
z ((X, Y : M, Z)) N(
1
2
ln
_
1 + r(X, Y : M, Z)
1 r(X, Y : M, Z)
_
,
1

N 3
)
(8)
which leads to
z((X, Y : M))z((X, Y : M, Z))
N
_
1
2
ln
_
1 + r(X, Y : M)
1 r(X, Y : M)
_

1
2
ln
_
1 + r(X, Y : M, Z)
1 r(X, Y : M, Z)
_
,
_
2
N 3
_
. (9)
When (X, Y : M) is signicantly dierent from (X, Y : M, Z), d(X, Y : Z) is signicantly dif-
ferent from zero. Thus the Students t-test is used to determine if (X, Y : M) and (X, Y : M, Z)
are dierent. Since N is large, the degree of freedom is also large, where the t-test is approxi-
mately the same as the Z-test (Chou 1975). In the next section, we propose a complementary
empirical statistical signicance test. The empirical approach overlaps with the Fisher trans-
formation approach, and is faster and simpler to evaluate. For real nite size data the two are
interchangeable, and the empirical approach is simpler to implement. Thus, after introducing
the empirical approach below, we will make use of it throughout the remainder of the paper.
2.3.2 Empirical statistical signicance test. Next, we introduce the empirical time se-
ries shuing statistical signicance method. For each time series that we study, we shue the
sequences of the returns, which destroys any correlations among these time series. The inuences

d(X, Y : Z) calculated from these time series should also be not dierent than zero. We shuf-
e the return time series of each stock by randomly rearranging the sequences of the returns.
The shuing process destroys correlations between each pairs of stocks returns, and between
stock returns and benchmark return, i.e. (X, Y ) and (X, M) should be zero, which leads to
d(X, Y : Z) equal to zero. By plotting the distribution of

d(X, Y : Z), we can nd the thresholds
of dierent signicant levels for d(X, Y : Z). In g. 2, we shue the return time series of 403
S&P500 stocks, and the index, and plot the distribution of

d(X, Y : Z) (solid black curve). As a
comparison, we plot the Gaussian distribution with same average and standard deviation value
in brown color. From the comparison, it is possible to observe that the empirical distribution of
of

d(X, Y : Z) has fat tails, and signicantly deviates from the case of a gaussian distribution
observed for random or shued data. The dashed lines represent the positions of one-tailed 1%,
6
February 7, 2014 Quantitative Finance khvhs04Feb14
5% and 10% signicance levels or two-tailed 2%, 10% and 20% signicance levels. We suggest
to make use of the two-tailed test, due to the fact that the signicant negative inuence is also
important. The red curve in g. 2 presents the distribution of empirical d(X, Y : Z). For the
case of the S&P500 companies example presented in g. 2, signicance level of 2% corresponds
to a z value (Equation 9) z > 1.6449; condence level of 10% corresponds to z > 1.2816; and
condence level of 20% corresponds to z > 0.8416 (see Table 2).
Table 2. Summary of two-tail signicance thresholds
Signicance level Threshold
1% 0.00152
2% 0.00108
5% 0.00081
10% 0.00057
20% 0.00037
-0.005 0 0.005
influence from a stock to a pair of stocks
0
400
800
1200
p
r
o
b
a
b
i
l
i
t
y

d
e
n
s
i
t
y

f
u
n
c
t
i
o
n

(
P
D
F
)
two-tailed 2% significance level
threshold=0.00108
two-tailed 10% significance level
threshold=0.000573
two-tailed 20% significance level
threshold=0.00037
-0.2 0 0.2 0.4
10
-4
10
-2
10
0
10
2
Gaussian
distribution
distribution of influence
from shuffled time series
distribution of influence
from empirical time series
Figure 2. Empirical statistical signicance test of inuence between nancial assets. We present the distribution
of inuence from one stock to pair of stocks, for the case study of 403 S&P500 companies, for a period of 11 years.
The black curve represents the distribution of the inuences,

d(X, Y : Z), calculated from the shued time series.
The dashed lines denotes the positions of one-tailed 1%, 5% and 10% signicance levels or two-tailed 2%, 10%
and 20% signicance levels. The distribution of

d(X, Y : Z) has an average value 9.9 10
8
, standard deviation
= 3.6 10
4
, skewness 9.5 10
7
and kurtosis 9.83. The brown curve represents the Gaussian distribution with
the same average value and standard deviation as the black curve. The red curve is the distribution of inuences,
d(X, Y : Z), calculated from the empirical stock return time series. We suggest to make use of the two-tailed test,
due to the fact that the signicant negative inuence values are also important. For the two-tailed test, signicance
level of 2% corresponds to z > 1.6449; condence level of 10% corresponds to z > 1.2816; and condence level of
20% corresponds to z > 0.8416. The inset shows the full empirical distribution.
As discussed above, while the two methods are interchangeable in respect to the resulting
signicance levels, there are additional benets to using the empirical approach. The empirical
shuing method conserves the distribution of returns without requiring ad-hoc assumptions
on the underlying distribution of the data. Furthermore, the empirical approach can also be
expanded to meet stricter requirements. For example, if the short term time series structure is
7
February 7, 2014 Quantitative Finance khvhs04Feb14
required to be conserved, the whole time series can be divided into segments with a given length
and we can than shue the segments without changing the sequence of time series within the
segments.
The empirical statistical signicance test allows a selection of signicant inuence relation-
ships between the investigated nancial assets. In previous work (Kenett et al. (2010)), this was
achieved by using dierent network based approaches, which than further allowed to investigate
the nature of these relationships. Below we propose two new applications of this methodology,
using the empirically statistically signicant values of d(X, Y : Z). The signicance level used
through out the paper is the z > 1.6449, corresponding to two-tailed 2%.
3. Market structure and its stability
High correlation between two stocks at a given time do not necessarily guarantee high correlation
in the future, because the behavior of stocks in nancial markets evolve. In certain markets,
companies change their strategies faster than in the other markets, which can be uncovered by
the partial correlation analysis of the behavior of their stocks. If the companies tend to keep their
past strategies, then the level of partial correlation between two companies stocks tends to be
stable. While in markets where companies switch their strategies more quickly, two companies
which had similar behavior in the previous year might have quite dierent behavior in the next
year. In such markets, partial correlation between stocks should be more volatile.
We apply the partial correlation inuence analysis to study the stability of the market struc-
ture. Specically, we dene the average inuence d(X) of stock X on all the other stocks in the
market as
d(X) d(X : Z) , (10)
where is the average over all Z stocks. We rank the stocks by their d(X) values, which we
consider as a representation of the structure of the market. By dividing the 11 year period into
44 quarterly periods, we can compare similarity of the market structures (ranking of stocks) in
dierent years. Kendall rank correlation coecient (Kendall 1938) is applied to measure the
similarity of the orderings for dierent periods. Let (x
1
(t), x
1
(t

)), (x
2
(t), x
2
(t

)), ..., (x
n
(t), x
n
(t

))
be a set of rankings of the variables X for dierent periods t and t

respectively. Any pair of

observations (x
i
(t), x
i
(t

)) and (x
j
(t), x
j
(t

)) are said to be concordant if both x

i
(t) > x
j
(t)
and x
i
(t

) > x
j
(t

) or if both x
i
(t) < x
j
(t) and x
i
(t

) < x
j
(t

). Otherwise, they are said to be

discordant. The Kendall coecient is dened as
=
number of concordant pairs number of discordant pairs
1
2
n(n 1)
, (11)
where if two rankings are the same, is one, if two rankings are independent, is zero, and if
two rankings are discordant, equals minus one.
In gure 3, we present the Kendall coecient for each dierent quarter pairs for the four
investigated markets. Generally speaking, each market shows that the longer the time interval
the smaller the rank correlation coecient, meaning lower similarity between the market struc-
tures for the two quarters which are compared. Comparing the rank correlations for the four
markets, we nd that S&P 500, FTSE 350 and Nikkei 500 stocks show strong market stability
patterns, while Indian BES 200 stocks almost do not demonstrate any stable patterns. This
can be understood by considering that developed markets tend to keep their market structure
longer than fast developing markets. Furthermore, it is possible to observe that for the US mar-
ket there were structural changes in the market following the dot comcrisis of 2000 and the
credit crunchcrisis of 2008. These can be identied in gure 3 by the red rectangle in the upper
left corner for the former (Q4 of 2000 till Q4 of 2001), and the red rectangle in the bottom right
8
February 7, 2014 Quantitative Finance khvhs04Feb14
S&P 500
2000 2005 2010

2000
2005
2010
FTSE 350
2000 2005 2010

2000
2005
2010
Nikkei 500
2000 2005 2010

2000
2005
2010
BES 200
2000 2005 2010

2000
2005
2010


0.2 0 0.2 0.4 0.6 0.8 1
Figure 3. Kendall correlation coecient of stock rankings in dierent quarters. The total investigated period
of 11 years is broken down into 44 quarters. For each quarter, we calculate the average inuence of each stock,
and rank the stocks according to their inuence. We then use the Kendal correlation to quantify the similarity
between every possible quarter pair, for the four investigated markets. The color code is used to present the
strength of the correlation, ranging from blue for negative rank correlation to red for positive rank correlation.
corner for the latter (Q4 of 2007 till Q4 of 2008). These rectangles present a strong similarity in
the structure during the two crises, followed by consecutive quarters with low values of thee rank
correlation, representing the change in structure. Studying the other markets, it is also possible
to observe the structural changes resulting from the 2008 nancial crisis in the UK, but not in
the structure of Japan or India.
To further quantitatively study the market stability, we plot the correlation coecient of two
rankings against the time interval of these two rankings (g. 4). By averaging the correlation
coecients for each time interval, we can study how correlation coecients decay as time evolves.
We nd the decay of the rank correlation coecients follow an approximate exponential process,
=
0
e
t/
, as shown in the insets in g. 4. Parameter
0
describes the consistency of the rankings
between two consecutive quarters. The larger
0
is, the more consistent two consecutive ranking
are. The parameter describes the characteristic time after which the correlation coecient
decays. Larger values mean longer persistence period, and thus describe the change in inuence
ranking across time. These two parameters together describes the stability of the markets. For
the investigated markets, we obtain the following values: US -
0
= 0.28, = 16.2; UK -
0
=
0.22, = 19.8; Japan -
0
= 0.2, = 18.8; and India -
0
= 0.17, = 42.9. As can also be
observed in gure 3,
0
has the largest value for the S&P500 case, and smalls value for the
BES200 case; however, the persistence in India is largest (as represented by the values of ).
We observe that the results for the Indian market dier from the other three markets. This is
possibly related to the dierences observed between developing and developed markets.
Put together, these analyses provide new insights into the dynamics of nancial markets. Using
the
0
and parameters, can help in monitoring structural changes in the market, and their
persistence. Thus, this methodology presents a unique tool for regulators and policy makers to
monitor the stability and robustness of nancial markets.
9
February 7, 2014 Quantitative Finance khvhs04Feb14
0 10 20 30 40
interval quarters
0
0.1
0.2
0.3
0.4
K
e
n
d
a
l
l

t
a
u

r
a
n
k

c
o
r
r
e
l
a
t
i
o
n

c
o
e
f
f
i
c
i
e
n
t
0 10 20 30 40
0.01
0.1
=16.2
S&P 500

0
= 0.28
0 10 20 30 40
interval quarters
-0.1
0
0.1
0.2
0.3
0.4
K
e
n
d
a
l
l

t
a
u

r
a
n
k

c
o
r
r
e
l
a
t
i
o
n

c
o
e
f
f
i
c
i
e
n
t
0 10 20 30 40
0.01
0.1
=19.8
FTSE 350

0
= 0.22
0 10 20 30 40
interval quarters
0
0.1
0.2
0.3
0.4
K
e
n
d
a
l
l

t
a
u

r
a
n
k

c
o
r
r
e
l
a
t
i
o
n

c
o
e
f
f
i
c
i
e
n
t
0 10 20 30 40
0.01
0.1
=18.8 Nikkei

0
= 0.2
0 10 20 30 40
interval quarters
-0.1
0
0.1
0.2
0.3
0.4
K
e
n
d
a
l
l

t
a
u

r
a
n
k

c
o
r
r
e
l
a
t
i
o
n

c
o
e
f
f
i
c
i
e
n
t
0 10 20 30 40
0.01
0.1
= 42.9 BSE 200

0
= 0.17
Figure 4. Kendall tau correlation coecient between rankings v.s. time interval between rankings. By averaging
the correlation coecients for each time interval, we can study how correlation coecients decay as time evolves.
We nd the decay of the rank correlation coecients follow an approximate exponential process, = 0e
t/
.
Parameter 0 describes the consistency of the rankings between two and consecutive quarters. The larger 0
is, the more consistent two consecutive ranking are. The describes the speed that the correlation coecient
decays as time evolves. Larger means longer decay period and smaller decay speed. These two parameters
together describes the stability of the markets. For the investigated markets, we obtain the following values: US
- 0 = 0.28, = 16.2; UK - 0 = 0.22, = 19.8; Japan - 0 = 0.2, = 18.8; and India - 0 = 0.17, = 42.9.
4. Quantifying the inuence of economic sectors
As our society becomes more and more integrated, production activities from dierent industries
depend upon and inuence each other. Categorizing a company into only one industrial sector
can not reect its whole performance and associated risk. Many listed companies in the stock
market belong to conglomerates, conducting their business in dierent industry sectors, hence
these companies performance will naturally be inuenced by multiple industries. Even if a
company only conducts its business in one sector, its performance can still be inuence by other
sectors because of the division of labor in modern society. For example, Alcoa Inc. as the worlds
third largest producer of aluminum is listed in the materials sector in NYSE. However, the
production of Alcoa Inc. requires dedicated supply of energy, e.g. Alcoa accounts for 15% of
State of Victorias annual electricity consumption in Australia. Thus their performance is also
heavily inuenced by and contributes to the performance of the energy sector. In this section,
we present an application of the partial correlation methodology to study the multiple-sector
inuence on stocks. We use the sector classication from the Global Industry Classication
Standard (GICS).
To study the inuence on a stock X from dierent sectors, we rst calculate the inuence
d(X : Z) (eq. 6) from all other stocks Z. The analysis in this section is performed for the entire
investigated time period. Next we calculate the average inuence by sector, in which we use the
10
February 7, 2014 Quantitative Finance khvhs04Feb14
sector categorization information of other stocks, as follows
d
S
X
=
1
N
S
NS

ZS=1
d(X : Z
S
), (12)
where X represents the investigated stock, S represents a given sector, N
S
is the number of
stocks in sector S and Z
S
represents the stocks in sector S. The average inuence d
S
X
reects the
level of inuence that stock X receives from sector S. After we normalize the average inuence,
we can attribute stock Xs performance to sectors performances with coecients

S
X
=
d
S
X

S
d
S
X
. (13)
In gure 5, we present an example of four typical stocks to show the pie picture of
S
X
. We
can see from the gure that in the case of Alcoa Inc., we observe signicant inuence from the
energy, materials and industrials sector. In the case of Franklin Templeton Investments, we nd
that the largest inuence is from the nancials sector. In the case of GE, we nd that the main
inuence stems from the materials, utilities, and nancial sector. Finally, studying the example
of Apple, we nd that there is a more homogeneous division of the inuence between the dierent
sectors. This could possibly indicate that out of these 4 companies, Apple is the most diverse in
its activities, being inuenced almost uniformly by dierent sectors of the economy.
Figure 5. Fraction of inuence from each sector to example stocks, Alcoa Inc., Apple Inc., Franklin Templeton
Investment and General Electrical. we present an example of four typical stocks to show the pie picture of
S
X
. We
can see from the gure that in the case of Alcoa Inc., we observe signicant inuence from the energy, materials
and industrials sector. In the case of Franklin Templeton Investments, we nd that the largest inuence is from
the nancials sector. In the case of GE, we nd that the main inuence stems from the materials, utilities, and
nancial sector. Finally, studying the example of Apple, we nd that there is a more homogeneous division of the
inuence between the dierent sectors. This could possibly indicate that out of these 4 companies, Apple is the
most diverse, as its business is aected by dierent sectors of the economy.
Finally, we perform a validation test on the the partial correlation analysis results, investigating
11
February 7, 2014 Quantitative Finance khvhs04Feb14
whether the result of multi-sector inuence on stocks is plausible. To this end, we rst rank all
the stocks in the S&P500 dataset by their fraction of inuence (
S
X
) from the nancials sector.
We then investigate what are the economic sectors inuencing these stocks, according to the
rank. We nd that the top stocks in the ranking according to our partial correlation analysis are
dominantly classied into the nancials sector. We repeat this analysis for all other economic
sectors. Indeed, all other sectors show that our analysis is in agreement with the GICS sector
classication. To quantitatively show this agreement, we calculate the correct prediction rate.
According to the GICS, we nd the total numbers of stocks (N
S
) in all sectors. From the ranking
of stocks according to the inuence from a given sector, we select the N
S
top stocks. We then
calculate the fraction of these top stocks that are classied by GICS into that certain sector as
the correct prediction rate. If the partial correlation analysis prediction is in total agreement
with the formal classication, then this correct prediction rate should be 1. If the prediction
corresponds to the case of random picking, this correct prediction rate should be
NS
N
, where N is
the total number of stocks. In gure 6(c), we show that the partial correlation analysis of sector
keeps a high correct prediction rate for all sectors, except the telecommunications sector, which
could be related to the small number of telecommunication stocks that are part of the S&P500
index. An alternative interpretation to these results is that the nancials and energy sectors are
both highly cohesive sectors of economic activity. This means that the activity in these economic
sectors is mainly contained inside each sector, with little inuence of external economic sectors.
Other sectors, such as Industrials and Materials, have stronger dependencies on other sectors,
and are strongly inuenced other sectors activities. Repeating this analysis for shorter periods
of time, or combining the analysis with a moving window approach, could provide meaningful
insights into the degree of interdependencies between the dierent economic sectors over time.
COND CONS ENR FIN HC IND IT MAT TELCOM UTI
0
0.2
0.4
0.6
0.8
1
F
r
a
c
t
i
o
n

o
f

c
o
r
r
e
c
t

p
r
e
d
i
c
t
i
o
n


partial correlation pick
random pick
Figure 6. Partial correlation test of the extent of sectorial inuence. To this end, we rst rank all the stocks in
S&P 500 by their fraction of inuence (
S
X
). We plot the fraction of true prediction of stocks sector from partial
correlation analysis (red solid curve). The blue dashed curve is for the case of random picking strategy, for the
purpose of comparison.
After studying the amount of inuence that stocks receive from dierent sectors, we nd
that some sectors tend to inuence the same stocks concurrently. We thus study the Pearson
correlation of inuences from two sectors to the same stocks, i.e. (d
Si
, d
Sj
), where d
Si
represents
the vector variable of inuence from sector i to all stocks. Applying this denition of sector
correlation to the S&P 500 data results in values that are presented in the rst panel of gure 7.
We nd that in the S&P 500 index, the pairs of industrials sector and consumer discretionary
sector, materials sector and industrials sector and the communications sector and the technology
sector are very close to each other, in terms of their inuence. Whenever a stock is highly
inuenced by one of these sectors, the other in the pair also tends to be inuential to this stock.
We also notice some dark blue area, e.g. the correlation between the utilities sector and the
consumer discretionary sector, which means when a stocks is highly inuence by one of the
them, the other tends to be of little inuence to the stock. We also study the UK FTSE 350
12
February 7, 2014 Quantitative Finance khvhs04Feb14
index, the Japanese Nikkei 500 index and the India BES 200 index. They all commonly show
high correlation between materials sector and industrials sector.
C
O
N
D
C
O
N
S
E
N
R
F
I
N
H
C
I
N
D
T
E
C
H
M
A
T
C
O
M
U
T
I
S&P 500
COND
CONS
ENR
FIN
HC
IND
TECH
MAT
COM
UTI
M
A
T
C
O
M
C
O
N
F
I
N
H
C
I
N
D
S
R
V
T
E
C
H
U
T
I
FTSE 350
MAT
COM
CON
FIN
HC
IND
SRV
TECH
UTI
M
A
T
C
O
M
C
O
N
E
N
R
F
I
N
I
N
D
T
E
C
H
U
T
I
Nikkei 500
MAT
COM
CON
ENR
FIN
IND
TECH
UTI
M
A
T
C
O
N
G
C
O
N
F
I
N
H
C
I
N
D
S
R
V
T
E
C
H
U
T
I
BES 200
MAT
CONG
CON
FIN
HC
IND
SRV
TECH
UTI


1 0.8 0.6 0.4 0.2 0 0.2 0.4 0.6 0.8 1
Figure 7. The correlation of inuences from two sectors to the same stocks, i.e. (d
S
i
, d
S
j
), where d
S
i
represents
the vector variable of inuence from sector i to all stocks. We represent the correlation using a heat map of
closeness between sectors in dierent markets, using a color code to represent the strength of the correlation,
ranging from blue for full anti correlation, to red, for complete correlation. We observe that for the S&P 500 data,
the pairs of industrials sector and consumer discretionary sector, materials sector and industrials sector and the
communications sector and the technology sector are very close to each other, in terms of their inuence, and an
anti correlation between the utilities sector and the consumer discretionary sector. For the case of the other three
investigated markets - the UK FTSE 350 index, the Japanese Nikkei 500 index and the India BES 200 index - we
nd that all show high correlation between materials sector and industrials sector.
5. Summary
This work presents a more general, statistically robust framework of the dependency network
methodology introduced by Kenett et al. (2010). Using the dependency network methodology, we
apply the partial correlation analysis to uncover dependency and inuence relationship between
the dierent companies in the investigated sample. Here we present a new statistically robust
approach to ltering the extracted inuence relationships, by either using a theoretical or an
empirical approach. The inuence method introduced in this study is generic and scalable,
making it highly accessible to both policy makers and practitioners.
Here, we present two possible applications of this methodology. First, we study the stability
of nancial market structure and show that developed markets such as the US, UK, and Japan
exhibit higher degree of market stability compared to developing countries such as India. Second,
we show that one stock can be inuenced by dierent sectors outside of its primary sector
classication.
While nancial analysts are usually specialized in one industry sector, a broader perspective of
equity research is required to grasp the insights of stock performance expectations. The presented
methodology provides new information on the interaction between dierent assets, and dierent
economic sectors. Such information is valuable not only for investors and their practitioners, but
13
February 7, 2014 Quantitative Finance khvhs04Feb14
also for regulators and policy makers.
Acknowledgements
We wish to thank ONR (Grant N00014-09-1-0380, Grant N00014-12-1-0548), DTRA (Grant
HDTRA-1-10-1- 0014, Grant HDTRA-1-09-1-0035), NSF (Grant CMMI 1125290), the Euro-
pean MULTIPLEX (EU-FET project 317532), CONGAS (Grant FP7-ICT-2011-8-317672), FET
Open Project FOC 255987 and FOC-INCO 297149, and LINC (no. 289447 funded by the ECs
Marie- Curie ITN program) projects, DFG, the Next Generation Infrastructure (Bsik), Bi-
national US-Israel Science Foundation (BSF), and the Israel Science Foundation for nancial
support.
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