MEASURING SHOCK IN FINANCIAL MARKETS

Abstract

Analogous to the Richter scale for earthquakes, we introduce the Scale of Market Shocks (SMS), an "event" scale to quantify the size of shocks in financial markets. It is based on price volatilities and computed by integrating volatilities over time horizons ranging from 1 hour to 42 days. The SMS is computed using quality high frequency market data and can be constructed for any market. We compute the SMS for the foreign exchange market. For two major FX rates, we study the relation between SMS peaks and major "world events". We measure also the correlation between the Scale of Market Shocks index and the size of the subsequent price movements and show a high correlation for short time intervals.