A Liquidity-Based Stock Network

Abstract

Stocks are connected through common ownership of financial institutions. Firm shocks can be transmitted and amplified through these inter-connections, aggregating into market level fluctuations. Using natural disasters as exogenous shocks, we provide evidence on the propagation effect through both direct and indirect liquidity-based linkages. We further construct a parsimonious network model using mutual fund holding data. The model allows us to quantify the extent to which firm shocks can be propagated into other stocks and the aggregate market. We find that the network structure can forecast the volatility of and correlation between individual stock's future returns and predict subsequent volatility of aggregate market returns.

Keywords: network, systemic risk, amplification mechanism, liquidity shock, mutual fund