# Application of Signal Processing to the Analysis of Financial Data

```[in the SPOTLIGHT]
Konstantinos Drakakis
Application of Signal Processing
to the Analysis of Financial Data
A
s the current recession grew
to the point of being considered the worst economic
downturn since the Great
Depression of 1929, the
news media has not only covered daily
developments, but it has also discussed
its causes and the lessons that can be
learned. A few of the published articles,
such as [1] and [2], shed some light on
the fact that signal processing techniques play an important role in
today’s finances. Indeed, today’s financial analysis and risk managers depend
on mathematical tools that, at their
core, are based on signal processing
techniques. In this article, we highlight some of these techniques used to
represent and predict the main features of price evolution and to classify
stock so as to design diversified investment portfolios.
IS SIGNAL PROCESSING USEFUL IN
ANALYZING FINANCIAL DATA?
Assume a manufacturer is asked by a client to sell some stock products to him at
any moment in time that the client
chooses within the next six months, but
at today’s prices rather than that
moment’s prices. Obviously, the client is
prepared to pay today a premium to the
manufacturer for the privilege of exercising this option. How much should the
manufacturer ask so that the deal proves
profitable for him? And how will the client choose the optimal point in time to
exercise the option he paid for? Both the
client and the manufacturer will have to
monitor the price of the product and
extrapolate its future evolution according to past available information. Viewing
Digital Object Identifier 10.1109/MSP.2009.933377
the price as a signal, this is a classical
problem in signal processing.
Assume now an investor wishes to
build a portfolio out of several available
stocks. The principle of portfolio diversification stipulates that the stocks
selected to be included in the portfolio
must be as uncorrelated as possible to
reduce the risk due to price fluctuations
VIEWING THE PRICE AS
A SIGNAL, THIS IS A
CLASSICAL PROBLEM
IN SIGNAL PROCESSING.
(this is an application of the law of large
numbers). In effect, then, each stock is
viewed as a mixture of “hidden market
trends,” and the investor’s goal is not
only to determine these trends but also
which stocks depend on which trends to
estimate their correlations. This is a
direct analogue of the canonical example in sound source separation, known
as the “cocktail party problem”: in a
cocktail party, the signals reaching our
ears are brouhahas of dozens of voices
(corresponding to stock prices), and yet
somehow we are able to isolate and
focus on a specific speaker (corresponding to the hidden market trend).
TOOLS AND MODELS TO
ANALYZE FINANCIAL DATA
A discussion of signal processing techniques in finance must necessarily begin
with the Black-Scholes [7] model for price
evolution. This is an excellent example of
mathematically rigorous signal modeling
that opened the door for the introduction
finance and earned the Noble prize of economics to its inventors.
THE BLACK-SCHOLES MODEL
The most common signals in finance
are prices (of goods, options, etc.), and
a simple description of such a signal
can be extracted from first principles
and confirmed by fitting on financial
data. Assume we know the price S 1 0 2
at t 5 0; how does the price S 1 t 2 evolve
within a short time interval thereafter?
The relative price increase (or decrease)
between times t and t 1 dt, when dt is
small, can be considered to consist of a
linear term of slope r plus a random normal fluctuation of zero mean and variance proportional to dt (namely s2dt,
where s is known as the volatility)
S 1 t 1 dt 2 2 S 1 t 2
5 rdt 1 sN 1 t 2 &quot;dt.
S1t2
We assume here that any two normal
random variables N 1 t 2 and N 1 tr 2 corresponding to nonoverlapping intervals
3 t, t 1 dt 4 and 3 tr, tr 1 dt 4 are independent. At the limit when dt S 0, this can
be written as
dS 1 t 2
5 rdt 1 sdW 1 t 2 ,
S1t2
where W denotes a random walk, namely a continuous function whose increments W 1 t 1 s 2 2 W 1 t 2 are normal
random variables of zero mean and variance equal to s, and such that increments over nonoverlapping intervals are
independent. The framework within
which such stochastic differential equations are studied is known as It&ocirc;’s calculus [2], where this equation can be
shown to admit the following closed
form solution:
S 1 t 2 5 S 1 0 2 e1r2 1s / 222 t1sW1t2.
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[in the SPOTLIGHT]
continued from page 160
This is the basic form of the BlackScholes model. Comparison to real data
reveals a certain degree of oversimplification: it is not the final answer, but it certainly is a very successful first step,
For example, to model price evolution over longer time intervals, the obvious solution is to extend the model to
include time-varying (or even stochastic,
as a further step) r and s, so that
dS 1 t 2
5 r 1 t 2 dt 1 s 1 t 2 dW 1 t 2 .
S1t2
Even this extension, however, cannot
account for the large price jumps occasionally observed over very small time
intervals and that are not captured by
normal fluctuations. We can include
such jumps in the model by adding a
jump process J 1 t 2 , namely a piecewise constant function whose interjump times are independent and
whose jumps are typically given by a
distribution that lacks a variance and
often even a mean (e.g., a Cauchy
distribution)
dS 1 t 2
5 r 1 t 2 dt 1 s 1 t 2 dW 1 t 2 1 dJ 1 t 2 .
S1t2
Establishing a rigorous model for price
evolution is important from a theoretical
point of view, but, in practice, we seek
signal processing techniques to analyze
data sets (e.g., of actual price evolution).
For example, a technique found to perform very well in the cocktail party problem/portfolio creation mentioned in the
introduction is nonnegative matrix factorization (NMF).
NONNEGATIVE MATRIX
FACTORIZATION
NMF is very simple: we collect the m
observed signals of length n into an
m 3 n array Y (adding perhaps a constant to each signal to form nonnegative signals), and we determine an
m 3 k array A (the mixing array) and
a k 3 n array X (the sources array),
such that the factorization error
e 5 Y 2 AX is minimized. The number
of sources k is usually determined
through a “threshold effect:” increasing k beyond a certain value does not
reduce the error significantly. The
arrays A and X can be determined
through an iterative process.
Based on A, a clustering technique
(e.g., k-means clustering) can be used to
group the observed signals according to
the sources they depend on. In practical
terms, this means that we can now
choose one stock out of each group and
build our portfolio.
In the traditional approach to investing, stock groups were practically a
nonissue, because they were taken (by
mere convention, apparently) to reflect
different sectors: in other words, IT stocks
were grouped together in a group, pharmaceuticals stocks were grouped together
in a separate group, etc. Applications of
TODAY’S RECESSION IS
WIDELY RECOGNIZED TO
BE A MANIFESTATION OF
A CHANGE IN THE RULES OF
THE FINANCIAL GAME.
NMF on actual stock data (e.g., the
Dow-Jones index [4]), however, led to the
perhaps shocking result that, contrary to
common belief, grouping does not reflect
sector partition but rather spans across
sectors. This result stresses the importance of analyzing and monitoring the
market instead of relying on intuition.
EMPIRICAL MODE DECOMPOSITION
The Black-Scholes model expresses the
price variation of a stock in terms of a
trend plus a fluctuation. As mentioned
above, though, this is a theoretical model
that oversimplifies reality. In actual data
sets, fluctuation components over different time scales are observed: coarse time
scales reflect periodicities meaningful to
analysis and prediction, while fine time
scales reflect noise. Both the trend and
the fluctuations are important for the
prediction of future values of the stock.
How can all these components (trend
and fluctuations) be meaningfully and
reliably determined?
Periodicities are usually detected
through application of the Fourier transform, which, in our case, however, suffers from two obvious drawbacks: a) it
cannot cope with the nonstationarity
introduced by the presence of the trend,
and b) it chooses its expansion functions
(sines and cosines) in advance, hence it
tends to over-decompose: for example, a
periodic function that is close to (but not
exactly) a sine will be expanded into an
infinite series. Localized expansions, such
as the windowed Fourier transform or the
issue but still suffer from the latter.
The empirical mode decomposition
(EMD) [5] is specifically designed to
expand a function into a trend plus a
number of intrinsic mode functions
(IMFs), whose defining features are
a) that all local minima and maxima are
negative and positive, respectively, and
b) that their local mean is zero.
Clearly, sines and cosines fall in this
class, so IMFs can be viewed as “sines
with slowly varying amplitude and
frequency.”
To apply EMD, fit a (cubic) spline
interpolant through all local maxima
of the function (upper envelope), and
do the same for local minima (lower
envelope); then, compute the pointwise
average of the two interpolants (the local
mean) and subtract it from the function.
Repeat this process until the local mean
is zero everywhere (within some preset
tolerance). The resulting function is the
first IMF; this process is depicted in
Figure 1 for an example signal. Subtract
this IMF from the original function and
repeat on the remainder function to
obtain the second IMF. Repeat until all
IMFs have been recovered and the
remainder does not have enough local
extrema to continue: this is the trend.
PHASE-RECTIFYING
SIGNAL AVERAGING
An alternative approach to determining
hidden periodicities in price variations,
which can also be applied in conjunction
with EMD, is phase-rectifying signal
averaging (PRSA) [6]. Here, we adopt the
point of view that the signal at hand is
essentially the sum of periodic signals
plus some impurities (such as white
noise and spikes). PRSA constructs a
new signal, where periodicities appear
stronger and impurities weaker, so that
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periodicities can be reliably detected by
applying ordinary Fourier transform. For
this, we assume the signal is stationary
and, in particular, detrended: trend is
removed either by linear (or, in general,
polynomial) fitting, or through EMD.
To apply PRSA, we first determine
the m anchor points of the signal S,
namely the points of increase i where
S 1 i 2 . S 1 i 2 1 2 , labeled as i1, c, im,
and place a (rectangular) window of length
2L around each with the anchor point in
the middle. We then “fold’’ the signal, averaging over all windows. More explicitly,
we construct the auxiliary signal
1 m
,
S1 n 2 5 a S 1 n 1 ij 2 ,
m j51
n 5 2L, c, 21, 0, c L 2 1
4
3
2
1
0
–1
–2
–3
–4
–5
0
0.1
0.2
0.3
0.4
0.5
(a)
0.6
0.7
0.8
0.9
1
0
0.1
0.2
0.3
0.4
0.5
(b)
0.6
0.7
0.8
0.9
1
0
0.1
0.2
0.3
0.4
0.5
(c)
0.6
0.7
0.8
0.9
1
3
2.5
(edge effects can be dealt with in several
obvious ways). Finally, we take the
,
Fourier transform of S . A windowed version of PRSA exists where PRSA is applied
on sections of S, just like the windowed
Fourier transform.
THE FUTURE OF SIGNAL
PROCESSING IN FINANCE
Today’s recession is widely recognized to
be a manifestation of a change in the
rules of the financial game. Markets
expand due to globalization; investors’
numbers increase; investors are offered
an increasing number of increasingly
complex alternatives to invest in; abundant computational power gives investors the potential to be (or the illusion of
being) smarter. Indeed, today’s recession
is partly (mostly or exclusively, according
to some) attributed to mispricing “exotic”
investment options, a result of glorifying
brute force (i.e., computational power) at
the expense of the models and techniques used.
Finance and economy developed
for centuries without reference to advanced mathematics (and signal processing). Economists were trained by a
combination of tradition and psychology, being taught for each situation what
and above all to develop and trust their
instinct. Indeed, most established economy and finance textbooks (such as [8]
2
1.5
1
0.5
0
–0.5
–1
–1.5
1.5
1
0.5
0
–0.5
–1
–1.5
[FIG1] Showing the (a) first, (b) second, and (c) fifth iteration of the EMD algorithm on a
signal: the signal appears in blue, the upper envelope in green, the lower envelope in
red, and the local mean in light blue. It is clear that, as the iterations progress, the upper
and lower envelopes tend to become mirror images of each other and the local mean
tends identically to zero; as for the signal itself, it converges to the first IMF.
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[in the SPOTLIGHT]
continued
and [9]) tended to keep mathematical
prerequisites to an absolute minimum
(and only in their more recent editions
did they reverse this policy). Signal analysts were unaware of the potential of
their techniques in finance , simply because the financial system, organized in
its own way, never gave the impression
of needing their help, and financiers,
lacking a mathematical education, did
not seek answers to their plights in the
realm of mathematics.
The pioneering work of Fischer Black and Myron Scholes changed all that.
As a result of their work, mathematical
finance is offered as a course in more
and more mathematics and engineering
departments, and an increasing number of financiers and economists are
trained in computer simulations using
mathematical models and in financial
analysis using advanced signal processing techniques.
[best of THE WEB]
Careful quantitative risk analysis
seems to be the antidote to today’s recession. The “mathematization’’ of the
financial system places policy making in
the hands of the experts and increases
investors’ trust, as decisions are directly
based on realistic, observable, and reproducible quantitative analysis instead of
the “good hunch” of a “market-seasoned
veteran.” Signal processing is the reliable way to our financial future.
AUTHOR
Konstantinos Drakakis (Konstantinos.
[email protected]) is a research fellow in
the School of Electrical, Electronic, and
Mechanical Engineering at University
College Dublin (UCD), Ireland. He is
also affiliated with UCD’s Complex and
the Claude Shannon Institute for
Discrete Mathematics, Coding Theory,
and Cryptography.
REFERENCES
[1] J. Nocera. (2009, Jan. 4). Risk mismanagement. NY
Times Mag. [Online]. Available: http://www.nytimes.
com/2009/01/04/magazine/04risk-t.html
[2] (2009, Jan. 18). Letters to the editor: Risk management.
New York Times Mag. [Online]. Available: http://www.
nytimes.com/2009/01/18/magazine/18letters-t-.
html
[3] B. Oksendal, Stochastic Differential Equations:
An Introduction with Applications, 6th ed. New
York: Springer-Verlag, 2003.
[4] K. Drakakis, S. Rickard, R. de Frein, and A.
Cichocki, “Analysis of financial data using non-negative matrix factorization,” Int. Math. Forum, vol. 3,
no. 38, pp. 1853–1870, 2008.
[5] N. E. Huang, Z. Shen, S. R. Long, M. C. Wu,
E. H. Shih, Q. Zheng, C. C. Tung, and H. H. Liu,
“The empirical mode decomposition method and
the Hilbert spectrum for non-stationary time series analysis,” Proc. R. Soc. Lond. A, vol. 454, no.
1971, pp. 903–995, 1998.
[6] A. Bauer, J. W. Kantelhardt, A. Bunde, P. Barthel,
R. Schneider, M. Malik, and G. Schmidt, “Phaserectified signal averaging detects quasi-periodicities
in non-stationary data,” Physica A, vol. 364, pp.
423–434, 2006.
[7] I. Karatzas and S. Shreve, Methods of Mathematical
Finance. New York: Springer-Verlag, 2001.
[8] R. Dornbusch, S. Fischer, and R. Startz,
Macroeconomics, 10th ed. New York: McGrawHill, 2007.
[9] G. Hubbard, Money, the Financial System, and
2007.
[SP]
continued from page 154
genes, clustering, and classification. Many
existing computing technologies such as
statistic inference, neural network, data
mining, and pattern recognition work
well on these tasks. Some of these tools
are open source software so that you are
free to copy and redistribute them. MeV is
one of them and is a good starting point if
you are going to see what you can do
about gene expression analysis. It integrates several popular analysis tools [e.g.,
hierarchical clustering, K-means, significance analysis of microarrays (SAM), and
clustering affinity search technique
(CAST)] and supports various data formats. It can give you an idea of what you
need for analysis of gene expression data.
SYSTEMS BIOLOGY
http: //cytoscape.org/ (Cytoscape)
http: //www.genome.jp/kegg/ (Kyoto
E nc yclo p e dia o f G e ne s a nd
Genomes, KEGG)
http: / / w w w . b i o c o n d u c t o r . o r g /
(Bioconductor)
[tutorials]
components, systems biology, which
focuses on several components simultaneously, is the systematic study of
complex or integrated interactions of
gene, proteins, and biological reactions. The goal of systems biology is to
allow people to delve deeper into the
foundation of biological activities and
have a more general view on the function or mechanism of gene and protein. Because of the complex system, it
needs interdisciplinary studies that
involve statistics, computation, chemistry, and other fields to discover the
biological silhouette. These systems
biology works usually include a network of interaction or biological signal
pathway. KEGG is one of the most
famous pathway databases, and, by
some knowledge-based methods, it
provides information of cell and organism behaviors at the genomic and
molecular level. As for the network
of interaction, Cytoscape gives the
convenient visualization of molecular
interaction networks and has many
open source plug-in modules to help
users integrate the network with the
data of the gene profiles or analyze the
properties of the network and subnetwork. Bioconductor is a powerful open
source and open development software
project for the analysis and comprehension of genomic data. Because it is
based on the R project (http://www.
r-project.org/), users have many resources that they can do for data analysis, such
as gene expression analysis, sequence
and genome analysis, structural analysis, statistical analysis, and computational modeling.
AUTHOR
Jung-Hsien Chiang ([email protected]
ncku.edu.tw) is a professor in the Department of Computer Science and
Information Engineering at National
Cheng Kung University, Taiwan. He is
currently a visiting professor with the
Institute for Systems Biology, Seattle,
Washington.
[SP]
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