Monica Billio
Ca Foscari University of Venice - Department of Economics

Loriana Pelizzon
University of Venice - Department of Economics

Andrew W. Lo
MIT Sloan School of Management; MIT CSAIL; National Bureau of Economic Research (NBER)

Mila Getmansky
University of Massachusetts at Amherst - Eugene M. Isenberg School of Management - Department of Finance & Operations Management

Abstract

We propose several econometric measures of connectedness based on principal-components analysis and Granger-causality networks, and apply them to the monthly returns of hedge funds, banks, broker/dealers, and insurance companies. We find that all four sectors have become highly interrelated over the past decade, likely increasing the level of systemic risk in the finance and insurance industries through a complex and time-varying network of relationships. These measures can also identify and quantify financial crisis periods, and seem to contain predictive power in out-of-sample tests. Our results show an asymmetry in the degree of connectedness among the four sectors, with banks playing a much more important role in transmitting shocks than other financial institutions.