Application of the Absorption Ratio to Illustrate Financial Connectedness and Interlinkages

This paper provides further evidence of the need to consider interlinkages and coupling within the financial system, particularly their impact upon portfolio management and in assessing risk exposures. This is done through application of the Absorption Ratio (AR) to ten European banks and insurance companies. In this case, the AR does not appear to act as an early warning indicator of market turmoil, which is inconsistent with the findings of Kritzman et al (2010 and 2014). However, one principal component is identified as explaining 70 to 80% of the variability in the assets’ returns for some of the period under review, in particular during the time of most severe financial crisis. A high AR suggests the stocks are more tightly coupled and provides evidence of interlinkages across two subsectors and a number of countries within Europe – thereby illustrating the extent of financial linkages and the high degree of correlation across markets and subsequent ramifications for portfolio managers.