Title: A Dynamic Latent-Space Model for Asset Clustering 

Abstract:

Periods of financial turmoil are not only characterized by higher correlation across assets but also by modifications in their overall clustering structure. In this work, we develop a dynamic Latent-Space mixture model for capturing changes in the clustering structure of financial assets at a fine scale. Through this model, we are able to project stocks onto a lower dimensional manifold and detect the presence of clusters. The infinite-mixture assumption ensures tractability in inference and accommodates cases in which the number of clusters is large. The Bayesian framework we rely on accounts for uncertainty in the parameters’ space and allows for the inclusion of prior knowledge. After having tested our model's effectiveness and inference on a suitable synthetic dataset, we apply the model to the cross-correlation series of two reference stock indices. Our model correctly captures the presence of time-varying assets' clustering. Moreover, we notice how assets' latent coordinates may be related to relevant financial factors such as market capitalization and volatility. Finally, we find further evidence that the number of clusters seems to soar in periods of financial distress.