A financial network is any collection of traders, firms, banks and financial exchanges (intermediaries), with links between entities representing a direct transaction or the ability to mediate a transaction. Security holdings (e.g. stock of publicly traded companies) of firms can also be included in this network, where an edge between a stock and a firm would represent firm’s ownership of the stock.
Contents
History
The crash of Long-Term Capital Management (LTCM) was one of the first events that exposed the importance of financial networks, and in particular, hidden stock correlations. In the case of LTCM, financial correlations were much higher than expected between Japanese bonds and Russian bonds. LTCM took on a significant amount of risk (at one point leveraged 25:1), underestimating these correlations. The 1997 Asian financial crisis and the subsequent 1998 Russian financial crisis lead to a divergence of European, Japanese and U.S. bonds, causing the collapse of LTCM.
Applications
Due to lack of data, current applications of financial networks are primarily confined to stock correlation networks, interbank networks, and agent-based models. Some agent based finance models which utilize a limit order book are instances of financial networks, where traders are connected to at least one exchange, and the exchange mediates transactions between traders.
One primary area of study is cascades in financial networks, which helps scientists and policymakers determine how to mitigate financial crises.