Financial Econometrics and Empirical Market Microstructure

Outliers as Early Warning Signals

Outliers play a crucial role in early warning. Outliers are the first visible signal of a regime shift into abnormal markets as Early Adopters act on disruptive information. HSBC’s February 23, 2007 $10.5 bn subprime loss announcement caused a tripling of AAA subprime spreads in a single day (a 12 standard deviation outlier). Four days later, this disruptive information cascaded into broad equity markets as February 27 saw exceptional downside outliers from China to the U. S. The Dow Jones recording its 6th biggest daily surprise in over 100 years (Finger 2008) on that day. A —3.3 % drop would hardly appear noteworthy, except that it happened just as volatility reached historical lows and therefore represented a 7.8 standard deviation outlier. See Table 1 for the top 10 DJIA surprise since 1900.

The Value-at-Risk (VaR) backtesting[16] graph of the DJIA (Fig. 4) shows how the February 27th, 2007 outlier signaled the emergence of the subprime crisis in broader markets. Notice the classic endogenous pattern of escalating systemic risk as pent up invisible risk emerges as visible risk.

Fig. 5 Financials VaR backtesting chart. Source: Laubsch (2010a, b)

The VaR backtesting chart of U. S. Financials (XLF) from 2006 to 2010 (Fig. 5) shows an even more pronounced “death star pulse” of amplifying risk after the February 27 outlier.

7.1 Gold Outlier Case Study: 2012-2013

The gold bubble burst which started in late 2012 is a classic early warning case study. Figure 6 shows that a skew of positive outliers preceded gold’s peak in

Daily 95% Confidence VaR. .94 decay, GLD

Positive outlier clustering

Downside outlier clustering since Oct 2012, accelerating Jan, Feb and march 2013...

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Fig. 6 Gold VaR & outlier graph

October 2012, after which a skew to negative outliers preceded gold’s slide and precipitous drop of April 12-15.