Application of Chaos Theory in Financial Markets

(A minor project for Operations Management 1)

Submitted to Prof. Manoj Kumar Shrivastava

By: Lalima Bassi (12P025) Mayank Chandna (12P026)

Table of Contents

I.TABLE OF CONTENTS 1) Introduction to Chaos Theory

INTRODUCTION TO CHAOS THEORY

Almost all of us who enjoy watching Hollywood movies must have watched Chaos released in 2005 and the Butterfly effect series. These movies were the adaptations of the Chaos Theory and we might also have searched about it on the internet after watching them but what exactly is the Chaos theory all about and how it is applicable in various areas specifically in our case- The Financial markets? Well your search ends here. In the following sections we will try explaining about Chaos theory, its meaning and its History and after that we will explain through our report how Chaos theory can we used in the financial markets as a whole. So lets get started.

Chaos Theory
Chaos as we look up in the English dictionary means complete disorder or confusion. But as soon we add word theory to its meaning changes. Chaos is often associated and replaced by the word random but Chaos theory although involves disorder and confusion it does not involve in any way the randomness. In mathematics, chaos theory is used for describing the behaviour of certain dynamical systems that is the systems whose states evolve with time exhibiting dynamics which are highly sensitive to the initial conditions, properly referred to as the butterfly effect. Due to its sensitive nature which evolves itself exponentially because of perturbations in the initial conditions, their behaviour initially appear to us as completely random but in reality they are not random at all. These systems although completely deterministic i.e. their future dynamics are fully defined by the initial conditions associated to them, with no random numbers involved but because they appear to be random their behaviour is also known as deterministic chaos or now days simply chaos. The theory of complexity interfaces between chaos and order and address the problems of transition. Shown in the diagram below is the complexity being and interface to chaos and order

Most of the things in the nature that appears random to us might not be random at all, so chaotic behaviour is also observed in the natural systems, such as the weather, the dynamic of the satellites in the solar system. Currently almost no area no subject has remained untouched for the Chaos theory. Chaos theory is applied in mathematics, biology, economics, meteorology, physics, psychology, computer science, and robotics and even in the areas like philosophy and politics. So the systems that exhibit mathematical chaos are actually completely deterministic and therefore orderly; hence the when we use the word Chaos technically, it is at opposite to the generally perceived meaning, suggesting complete disorder and confusion. A related field of physics called quantum chaos theory studies systems that follow the laws of quantum mechanics. Another field has recently emerged known as the relativistic chaos which describe the systems that follow the laws of general relativity. Being deterministic the chaotic systems usually have statistics which are well defined. For example, the Lorenz system is chaotic, but has a structure which is clearly defined. We can see and observe the same in the Lorenz system curve given below. Bounded Chaos is another term which is used to describe such models of disorder.

Lorenz system

History and Development

Henri Poincar is said to first discoverer of Chaos. In 1890, while he was studying three-body problem, he discovered that there can be orbits which are non-periodic in nature, and yet never increases or approaches to a fixed point. In 1898 Jacques Hadamard published a path breaking study of the chaotic motion of a free particle sliding in a frictionless manner on the surface of negative curvature which was constant. The earlier theories on chaos were basically developed mostly by the mathematicians, who then named it as ergodic theory. Even after many useful insights during the beginning years of the twentieth century, the chaos theory could be formalized the way it is only after mid-century, when the scientists first understood that linear theory, which was the prevailing that time, was unable to explain the behaviour of certain experiments for example that of the logistic map. What was earlier disregarded as imprecision and simple noise was then started being considered by the chaos theories as a complete component of the studied systems .

The development of chaos theory as it is today is mainly attributed to the electronic computer. Mathematics involving the chaos theory mostly is the repeated iteration of simple mathematical formulas, which cannot be done manually. With the advent of electronic computers such repeated calculations became practical, added to this the figures and images thus produced by electronic computers made the visualization of such systems possible. Thus the earliest electronic digital computers were used to simulate and run simple weather forecasting models. In 1961, Edward Lorenz, an early pioneer of the chaos theory, developed interest in it accidentally due to his work on prediction of weather. He used a simple digital computer to run his weather simulation. To get more data and to save time he started the simulation in the middle of its course by entering the values from printout of the data corresponding to condition and results obtained in the middle of his simulation which he calculated previously. The results that he got completely surprised him as the weather the machine started predicting was completely different from the whether it predicted before. He then checked the values he used from the printout to that actually obtained from the computer. The computer he used could do calculations up to 6 decimal places, but during the printout process it was rounded off to 3 decimal places. For example a value like 0.413017 was rounded off to 0.413. The difference being tiny was at that time was perceived to have to have no effect on the results. However Lorenz through this therefore discovered that small changes in initial conditions produced large changes in the long-term outcome. This finding of Lorenz gave it a name of Lorenz attractors, proved that meteorology can never reasonably predict weather beyond a 7 days (a week). A year before Lorenzs discovered the chaos phenomena; Benoit Mandelbrot observed patterns at every scale in data on cotton prices. His work published in 1975 by the name The Fractal Geometry of Nature, which became a classic of chaos theory. Many elements in the biological systems especially the branching of the circulatory and bronchial systems was observed to be fitting the fractal model. Understanding the importance of Chaos the New York Academy of Sciences followed the suit and ended up organizing the first ever such symposium on Chaos in 1977. Mitchell Feigenbaum next year published the noted article "Quantitative Universality for a Class of Nonlinear Transformations", where he formulated and described logistic maps in detail. He had applied fractal geometry for studying natural formations in the nature such as coastlines and due to this he found the universality in chaos, allowing people to apply chaos theory for explaining and predicting many different phenomena. For his commendable work Mitchell J. Feigenbaum was awarded the Wolf prize in Physics in the year 1986.

Bernardo Huberman in 1986 presented a mathematical model of the eye tracking disorder among schizophrenics at the first such conference on Chaos in biology and medicine organized by New York Academy of Science and National Institute of Mental Health.

To make it familiar to the general public James Gleick came up with a book titled Chaos : Making a New Science in 1987 which became an instant bestseller and for th e first time introduced to the general public the history of development of chaos theory and general principles, on which it is based upon in a easy and understandable language. Since then lot people have published works on Chaos Theory giving a different perspective to it every time. The cheaper and powerful computers have today have broadened the applicability of chaos theory making it to be one of the most active area in the field of research, spanning across all disciplines of study. Having studied a great deal about Chaos Theory we must first move on to understand in the next section about the methodologies used predicting the financial markets and then finally to how chaos theory can be applied to financial markets.

Predicting the financial markets: Journey so far

One can't understand markets or women without getting involved Anonymous I just made a killing in the stock market - I shot my broker. Henny Youngman If past history was all there was to the game, the richest people would be librarians. Warren Buffett What these quotes have in common? Yes all these suggest to the one and only one point The unpredictability of the financial markets. No has ever been able to predict the financial markets. And why would anyone want to do that? The answer is simple To maximize the profits. In this section we will cover various aspects related to financial markets and the various techniques and attempts that have been made to predict the financial markets.

Financial Markets
These days capital is basically traded through the stock markets all around the world and no national economy can afford to neglect it as they are influenced heavily by the performance of their stock markets. Today stock markets have also become accessible to common people who are playing an important part along with the strategic investors. Not only they are related to the macroeconomic factors but they influence the everyday life of individuals as well. Therefore these markets have a direct social and economical impact on the people. One important characteristic that define all stock markets in the world is the uncertainty. Following are the trends of different stock markets over the periods. The graph below shows the performance of the Sensex over the 10 year period

Sensex last 10 years If we look into detail a more detail data of Sensex over a couple of years we find that randomness of the ups and down of the stock markets are even more observable.

Also below is the graph of the worlds most popular market NASDAQ, which shows its bullish trends over the years.

Such unpredictable behavior of the stock markets have always intrigued the people and motivated them to devise effective ways to in order to predict it as closely as possible. There are two schools of thoughts on the issue of whether to predict the stock markets or not. One group believes that markets are efficient themselves and correct themselves by absorbing the new information that comes from time to time leaving a very little space for prediction also known by the term - efficient market hypothesis (EMH) propounding that stock markets follow a random path and the best a person can do for predicting tomorrows value is by looking at todays value. The other group on the other hand believes that mechanisms can indeed be devised to predict the stock market. The prime motivation for them is help people in maximizing the profits. Broadly Categorized there are have been 5 major categories which try to predict the stock market returns 1. 2. 3. 4. 5. Technical Analysis methods Fundamental Analysis methods Traditional time series forecasting Machine learning methods New unscientific methods

The major criteria for such classifications are based on the type of data these methods use, type of tools and the type of processes they deploy. Lets discuss about all of them in brief in this section.

Technical Analysis methods

The basic guiding principle for the technical analyst also known as the chartist is 1. History repeats itself 2. To predict the future one must be fully aware of the past" Therefore they attempt predicting the market by looking at the past patterns from the charts describing the historical movement of the markets. As described generally Technical analysis is the method of predicting the appropriate time to buy or sell a stock used by those believing in the castles-in-the-air view of stock pricing". The basic idea is share price movement can be attributed to the ever changing investors response to various forces. Using prices, volume, dips in prices to highest and lowest during trading periods as data, the chartists use charts to predict the future movement of the stock prices. The trends are detected by the price charts thus prepared and are supposed to be based upon simple supply and demand, which are often cyclical in nature have patterns which are quite noticeable. Most of these chartists believe that almost about 90% of market is basically psychological while only 10% of it is logical. Although this is the most popular approach for predicting the markets it has been heavily criticized attributing to the fact that trading rules thus extracted from the charts lacks objectivity and are very subjective in nature, therefore different analysts would come up with different trading rules even if they study the same charts.

Fundamental Analysis Methods

Contrary to what technical analysts believe in, the fundamental analysts hold the view that about 90% of markets can defined by logical factors while only 10% by the physiological factors. They try finding out and studying the intrinsic value of a particular stock and if it is lower than the current value of the stock, they suggest investing in that particular stock. As described popularly - "Fundamental analysis is the technique of applying the tenets of the firm foundation theory to the selection of individual stocks". The proponents of this group therefore aim to compute the real value of the asset by studying the variables such as growth of that asset, the dividend paid, interest rates, risks associated with the investment, the level of sales, tax rates etc. They follow a simple rule if the intrinsic value calculated is higher than its current value; invest in it. If it is other way round then avoid it since it would be a bad investment.

Traditional Time Series Forecasting

Traditional Time Series forecasting involves the creation of linear prediction models for tracing patterns in the historical data observed so far. These are further divided into two regression models; the univariate and the multivariate depending upon the number of variables taken into account for approximating the time series of the stock market. Therefore the traditional time series prediction proceeds by first analyzing the historical data and then by approximating the values as a linear combination of these historical data. The two basic types of time series forecasting simple regression (known as univariate) and multivariate regression are used as the most common tools for predicting the time series. Regression models have been constantly used to predict time series of the stock market the pioneers in this field are the Pesaran and Timmermann. They tried predicting the time series of the S&P 500 and the Dow Jones on monthly, quarterly and annually basis.

Machine Learning Methods

Due to advancement in the technologies and computers a number of methods have evolved recently under a common name known as Machine Learning Methods. Commonality in these methods is that these methods use a set of samples and try tracing and indentifying patterns in it which can be both either linear or non-linear for approximating the underlying function that resulted in the in generation of the sample data. The basic goal from such process is to come to some conclusions in such a way that if unseen data are presented it is possible to come to an inference for to be explained variable from these data.

New unscientific methods

Whether fields like astrology and numerology really can be relied upon is matter of debate and subject to personal opinion but implementing it to predict the future of stock markets have made the matter even worse. A common layman person and even big investors no longer hesitate these days to consult to astrologers for getting future insights about the stock markets. These self proclaimed stock astrologers showcase their success rates of their predictions as against the scientific methods generally used. Whatever may they proclaim we are not going about such unscientific means of predicting the stock markets further.

Having discussed all these methods used in predicting the stock markets let us now discuss in the next section about how we can implement the chaos theory in predicting the financial markets. How it is different from the methods discussed so far. What are its advantages and the journey that lies ahead of us.

Financial Markets and Chaos theory

Chaos theory in Economics and Finance so far

As discussed in the previous sections, chaotic systems are complex systems which belong to the class of deterministic dynamical systems. Because of this, many phenomena which earlier appeared to us as random are now being detected possessing the qualities of chaotic models. Therefore the chaos is now being used in lot of fields for the purpose of control and forecasting by mathematicians and scientists. Systems like financial markets and economies are characterized by strong nonlinearity, permitting to take into account non-periodic fluctuations, mixing cycles and switches inside data sets. They are characterized by an invariant distribution function and their orbits evolve inside an attractor in which it is possible to do forecasts. Working inside an attractor also permits to control the system and to be able to avoid explosions and strong volatility, which is an interesting task for applications. In economics, people working on stability and instability are experimenting with bifurcation theory since the 1980s. Indeed, working with chaotic systems is in opposition to most of the different concepts developed by macro-economists like the neo-classical theory, the rational theory which uses linear concepts or, Keynes theory and is not concerned with complex systems. Chaos theory explains randomness endogenously. In finance the interest in chaos theory is more recent and sparse. The craze for this theory from financial people began around the nineties. People expected to get robust forecasts using chaos. People working with chaos theory in financial market, economics or even mathematicians use neither the same models, nor the same information set. Most mathematicians work with analytical expressions and characterize their models under specific assumptions to decide if they can exhibit specific chaotic behaviors, characterized by specific properties, following varied definitions of chaos. The economists generally use analytical systems corresponding to a specific modeling problem. These systems depend on few parameters and one purpose is to detect the range of these parameters in which they can lead to stable or unstable behaviors. Bifurcation theory is often a basis of their studies. In finance, practitioners do not use analytical systems and want to use chaos theory to robustify their forecasts: most of the work is empirical.

In statistics, work concerns estimation theory and tries to prove robustness of estimates of the Lyapunov exponents or the embedding dimension, for instance. They are also interested in re-building orbits and forecasting on the attractors.
Why we should be interested in Chaos theory for predicting the Financial Markets?

Nonlinear approaches to short-term forecasting employ chaotic attracters, making it possible to predict incipient crisis. It is doing so by dynamically examining time series taken near the catastrophic bifurcation threshold. This explains where chaos theory can be of help. It presents the possibility that systems that seemed to be random might actually be described by simple rules and, might therefore be predictable The aim is to develop models that generate rather accurate predictions, inspite of prevailing turbulence. This is doable provided that we have methods for devising nonlinear models directly from data streams. The aim is to apply prediction capabilities to financial markets and financial instruments, making it possible to reach a high degree of significance in terms of predictability: The goal of integrating complexity theory and prediction technology into trading system is not novel. What is novel is the type of tools now beginning to be used, which make the study of complexity feasible. The implementation of chaos theory in financial trading essentially embraces the dynamics of nonlinear solution spaces. A chaotic system can produce random-looking results, which however are not truly random, each chunk of values being limited within a given region. This gives the impression of a stochastic behaviour and at the same time makes long term forecasting impossible. The successive bifurcations exemplify the discontinuities that do not permit long-term forecasting. Within the region defined by a given bifurcation, there exists a sensitive dependence on initial conditions: Nonlinear dynamics do not only describe how complex systems change. They also suggest that a change in one input possibly has an effect out of all proportions to its size. Chaos affects any system that has some sort of sensitive dependence on initial condition, be it a financial market or a weather pattern. Any small change or uncertainty in conditions at a starting point will eventually make predictions about the system and its behaviour extremely difficult, If not impossible.

The point many people trained in traditional financial analysis fail to appreciate is that discontinuous changes require a sort of discontinuous thinking. Because of its upside-down characteristics, discontinuous thinking has never been popular with the upholders of continuity and the status quo nor with mathematicians tied to the classical theories. The following figure shows the infrastructure of a characteristic behaviour with non linear systems. This is the way swap markets work and the reason why avalanches occur: Minor fluctuations at the bottom of the tightly knit structure. Lead to significant impact at the final load level.

The way swap markets work, characteristic behavior with nonlinear systems

The basic concept underlined by this system is that world is not orderly, and this is as true of financial systems as it is of other human-made artefacts and of natural systems. The financial markets are not orderly even if, superficially, within a limited time frame market behaviour seems to be so: Money markets and capital markets are human creations, even if we find it difficult to understand how they work. Precisely in order to enhance understanding, traders and financial analysts have typically proceeded with oversimplification of reality

Deterministic and stochastic models used so far have improved upon guesswork performance, but have been too much based on simplifying assumptions. Whether working only through guesswork or by means of simple models, economists have led themselves to serious forecasting errors. And there is an echo effect as well. Because they understand that simplifications lead to disregard of problem information, economists and financial analysis tend to behave as a group at turning points. This in no way that takes into account the discontinuities and bifurcations embedded in real-life situations, yet the latter see to it that. Forecasts, even when correct, are relevant in only a short time frame. Even a small change in one variable tends to have a much bigger impact than classical theory suggests.

The stock market for instance, has more large changes in the longer run than economic theory and its simple linear models would predict. Neither did econometrics of the Leontief Input/ Output type provide a persistent ability to forecast our economic future and prepare accordingly. Some of the reasons lie with the concepts on which Input / Output models have been built (for instance, the concept of equilibrium). Chaotic model that can be used for predicting financial markets Markets are complex feedback systems in which participants may overreact to information. Linear risk-return relationship in return might be damaged due to complex nature of the markets, transaction cost, thin trading and high volatility. Feedback mechanisms imitate the dynamics of non linear systems since they have non-proportional relationships between risk and return. Linear behaviour in returns suggests that efficient market hypothesis is in question. Non linear dependencies in returns of financial instruments highlight chaotic patterns. The efficient market hypothesis is related to the rational expectations theory which states that market participants aim at maximizing expected returns from the investment with a risk appetite. However, the theory is contradicted by empirical results. Market participants should deal with transaction costs, different information sets and different time scales. Therefore, the expectations are heterogeneous and should be priced in non linear and complex methodologies. Neural networks, wavelets and fuzzy logic are the most commonly used methodologies in modelling chaotic behaviour in financial markets. Artificial neural networks are easily constructed computer based models. They are inspired by examining the human brain. Architecture of artificial neural networks imitates biological functions. They can be seen as

pattern classifiers. The information coming from input variables flows within the hidden layers in the network and trained with weighted connections, they have tolerance to noisy time series.

A typical Multilayer Neural network

A network has inputs, hidden and output layers. In general a neural network is constructed with multi layer neurons which are connected to each other. The input layers are the dependent variables or factors in the system. The inputs are passed to medium processing units labelled as hidden layers. The inputs are multiplied by a weight (wk ) selected randomly, end results are transformed to the other layers with a nonlinear transfer function. The hidden layer processes the input factors and passes the signals produce in the output layer. The process is repeated until the output reaches the desired level with an acceptable accuracy.

An activation function, which may be linear or nonlinear, maps input into a bounded range i.e. [0,1] or [-1,1].there are certain types of activation function, namely hyperbolic tangent, logistic, threshold, causal or sigmoid. According to Klimasauskas, the sigmoid unction works best when learning about average behaviour, while the hyperbolic tangent function works best when learning deviation from the average. In that framework, a single unit adaptive network with 2 binary inputs has the output below: 1 if W0*I0 +W1* I1+Wb>0 0 if W0*I0 +W1* I1+Wb<=0 The networks is expected to learn the following pattern: output 1 if either I0 or I1 is 1.By changing the amount weight by an amount proportional to the difference between the desired output and the actual output, the network is adapted. The process is called as perception learning rule and can be denoted as follows: Wi= *(DO-AO)Ii Where is the learning rate, DO is the desired output and AO is the actual output. In conventional econometric methods such as Auto regressive Moving Average, regression rules are strictly defined. Mathematical formulas design the dynamics of modelling. Artificial Neural Networks, on the other hand, do not perform according to the pre-defined rules. In that respect, neural networks have the ability to learn from input data and produce an accurate output for previously unseen input data even if time series of inputs containing missing data. As an alternative for neural networks, wavelets are developed in producing signals. According to wavelets, fixed time scales are not adequate for capturing the perception of

risk and return. Wavelets assess risk at different time scales and pass volatility from one scale to the other. Breymann display long term co relations from large to small time scales in return volatility. The wavelets capture volatility at different sampling rates introduced by Gencay and Selcuk. According to the model, wavelets capture the non linearities at a variety sampling rates simultaneously. According to Gencay and Selcuk by assuming that N is the longest dyadic piece of the series , multi resolution analysis should be performed down to level J, which is equal to log2 (N) on the squared return series. An additive decomposition is reached by the jth level wavelet detail Dj associated with change at scale j (j=1,2J) Ramsey lists five frameworks, in which wavelets are used namely, 1) Exploratory analysis 2) Density estimation and local inhomogeneity 3) Wavelets estimators 4) Time scale decomposition 5) forecasting As a signalling process, a wavelet has genders, father wavelets and mother wavelets .The father wavelets integrates to 1 and the mother wavelet integrates to 0.The father wavelets represents the low frequency part of the signal while the mother wavelet does high frequency part. A combination of neural networks and wavelets has been used to create an intelligent architecture system for example a discrete wavelet transform allows researchers to reduce the training time of the neural network. Integration model of joint time frequency filtering methods and neural networks has been developed. They have 2 kinds of integration approach;1)single recurrent neural network model combined with the filtering methods 2)multiple recurrent neural networks models combined with the filtering methods. It is possible to design alternative combined models with intelligent computer based system. The models vary on the capacity of the information systems used and random dream power of the researchers.

Application of chaotic models in finance

Intelligent systems contain unique quantitative methods for business that traditional methods in econometrics might not offer because of the complexity of the mathematical systems. Intelligent systems can be used in finance as following goals: Forecasting of financial and economic time series Credit approval Project management Credit default modeling Ratings of risk factors Detection of error terms of the financial data Predicting investors behaviors Constructing optimal capital structure

In financial literature, intelligent systems are generally used to model market risk factors such as exchange rates, interest rates and stock prices.

Future possibilities Conclusion Reference