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Endogenous Crashes as Phase Transitions

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  • Revant Nayar
  • Minhajul Islam

Abstract

This paper explores the mechanisms behind extreme financial events, specifically market crashes, by employing the theoretical framework of phase transitions. We focus on endogenous crashes, driven by internal market dynamics, and model these events as first-order phase transitions critical, stochastic, and dynamic. Through a comparative analysis of early warning signals associated with each type of transition, we demonstrate that dynamic phase transitions (DPT) offer a more accurate representation of market crashes than critical (CPT) or stochastic phase transitions (SPT). Unlike existing models, such as the Log-Periodic Power Law (LPPL) model, which often suffers from overfitting and false positives, our approach grounded in DPT provides a more robust prediction framework. Empirical findings, based on an analysis of S&P 500 stocks from 2019 to 2024, reveal significant trends in volatility and anomalous dimensions before crashes, supporting the superiority of the DPT model. This work contributes to a deeper understanding of the predictive signals preceding market crashes and offers a novel perspective on their underlying dynamics.

Suggested Citation

  • Revant Nayar & Minhajul Islam, 2024. "Endogenous Crashes as Phase Transitions," Papers 2408.06433, arXiv.org.
  • Handle: RePEc:arx:papers:2408.06433
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    References listed on IDEAS

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    1. D. Sornette & A. Johansen, 2001. "Significance of log-periodic precursors to financial crashes," Papers cond-mat/0106520, arXiv.org.
    2. Li LIN & Ruo En REN & Didier SORNETTE, 2009. "A Consistent Model of ‘Explosive’Financial Bubbles With Mean-Reversing Residuals," Swiss Finance Institute Research Paper Series 09-14, Swiss Finance Institute.
    3. D. Sornette & A. Johansen, 2001. "Significance of log-periodic precursors to financial crashes," Quantitative Finance, Taylor & Francis Journals, vol. 1(4), pages 452-471.
    4. Anders Johansen & Olivier Ledoit & Didier Sornette, 2000. "Crashes As Critical Points," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 3(02), pages 219-255.
    5. L. Lin & Ren R. E & D. Sornette, 2009. "A Consistent Model of `Explosive' Financial Bubbles With Mean-Reversing Residuals," Papers 0905.0128, arXiv.org.
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