Researchers from Tel Aviv University, in collaboration with the Kiel Institute of World Economy in Germany, have developed a new methodology that measures the interconnections between stock markets across the globe.

It has the potential to serve as an early warning system and provide measures to manage and mitigate the spread of financial crisis.

There’s nothing new in analyzing the correlations between stocks in an individual market, using parameters such as market index and volatility to determine whether prices of stocks will rise or fall in tandem. But with this project, the researchers have introduced the concept of the meta-correlation, in which they measure the average correlation of countries’ stock markets against one another. The result is a precise understanding of how changes in one market impact another. At worst, these connections can lead to a fast spread of financial crisis.

To develop their method, the researchers looked at data from six major world markets — the U.S., the U.K., Germany, Japan, China, and India — from the beginning of 2000 to the end of 2010. Choosing the leading stocks in each market, the team then mapped the correlations between the groups of stocks from each country over the 11-year period. With the exception of China, which tended to operate independently, the researchers discovered an interesting pattern of interdependencies between these markets. Some markets, such as the U.K. and U.S., were closely connected, as predicted. But there were also surprising findings, such the fact that Japan fluctuates in its financial alignment between western and eastern countries.

A Financial Seismograph

According to the researchers, this method of understanding market connections could help each country predict when a financial crisis is imminent, allowing it to set up policies that will protect their own markets from becoming dangerously intertwined with struggling markets. As Prof. Ben-Jacob of TAU’s School of Physics and Astronomy says:

In the current era, when the global financial village is highly prone to systematic collapses, our approach can provide a sensitive ‘financial seismograph’ to detect early signs of global crisis.

Citing Greece’s financial problems and their impact on the European market as a whole, Ben-Jacob’s Ph.D. student Dror Kenett continues:

There are different safety mechanisms that each country can implement. Germany is so invested in Greece that they don’t have an option other than to bail Greece out

noting that if it had been able to see the extent of their dangerous connection with Greece, Germany could have opted to reduce its investments earlier.