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Wallace 67
NEURAL NETWORKS AND THEIR APPLICATION
TO FINANCE
Abstract
Neural networks are one such process, that is, it maps some type of input stream of information to
an output stream of data. It consists of ways to connect data/information to produce output that is
consistent with the processes. It may seem simple, but as the analysis will highlight, this process is far
from trivial. Today neural networks have been integrated into most fields and are a very important
analytical tool. Neural networks are trained without the restriction of a model to derive parameters and
discover relationships, driven and shaped solely by the nature of the data. This has profound
implications and applicability to the finance field. These areas will be analyzed with specific examples in
each area.
The human brain is a very complex part THE HISTORY OF NEURAL
of the human body, due mainly to the NETWORKS
interactions and connectivity with other
parts of our body, and the way it controls Neural networks were originally
and defines every aspect of our being. The devised to understand the workings of the
brain has continued to be a mystery to human brain (a formidable task).
many scientists, but its role and capacity to However, there developed a
process information is mimicked in many multidisciplinary trend with the constant
aspects of academia. Neural networks are interaction of researchers across
one such process, that is, it maps some disciplines who tried to apply the
type of input stream of information to an neurological activities of the brain with
output stream of data. It consists of ways classifying computer programs and
to connect data/information to produce functions (Stergiou and Siganos para 5).
output that is consistent with the
processes. It may seem simple, but as the Figure 1: Neural Networking and
analysis will highlight, this process is far Similarities with the Workings of the
from trivial. Human Brain
A neural network works in a similar
methodological way to connect processing
elements to produce results from a
complex analytical study or principle that
depends on many interconnected
explanatory variables. According to Smith
initially neural networks were
characterized as a computer science
phenomenon with uses (Smith para 2):-
• processing elements
• a high degree of
interconnectivity
• dependence of variables
The first use and concept of neural and research associated with neural
networks began with linear classifications networks. Its overall use and
of the input-output relation represented computational ability to solve complex
generally equation 1 below: problems was questioned and this lead to
limited use.
Y = a + bx, with x Є Rn, a Є Rn, b Є Rn Nevertheless, neural networks have
regained popularity and are being used in a
Equation 1 wide array of fields within the natural and
Equation 1 was the typical development social sciences. Models such as those in
in neural networks and classified the figure 2 generally increased in complexity,
general form of the Perceptron, which the development of the Cognitron in 1975
developed considerable interest and with training and learning algorithm, along
research in the 1950s (Stergiou and with the ability to change weights and
Siganos para 6). This model clearly has interactivity across input sets in Rn, were
limitations, since it can only specify linear developed and re-popularized the field.
relationships in the input space; and will Other popular models such as the back-
not classify complex data models that have propagation network is which utilized a
a non-linear relationship. stochastic function to generalize the
Neural networks continued to advance relationship and determine optimal
and developed a multilayered algorithm parameters of a complex model via a more
that had the ability for bi-directional flow robust methodology (Stergiou and Siganos
on inputs. Figure 2 below, highlights the para 8). Equation 2 below highlights the
general neural model that was adapted and complexity and development within the
transformed across disciplines. It historical timeline that shows the
highlights the development and historical sequential development of neural networks
progress of neural networks as its (note the difference between equation 1
applicability across research arenas and equation 2).
changed (Stasoft para 20).
Y =h (a + bx), with x Є Rn, a Є Rn , b Є
Figure 2: Multilayered Neural Network Rn
Model adapted from Stergiou and
Siganos where h is a logistic function
Equation 2
Inputs
Analytical Output
Processing
Data along the Input All data inputs into Summation value is
input lines to a representations the neuron are analyzed put through a transfer
neuron are sometimes display and checked for function, whose output
multiplied by the interconnectedness. interconnected represents the neuron’s
line weights relationships that can output values
impact the output.
Weights are adjustable parameters that The simplest transfer function is the linear function, whose
are adjusted during the training phase to output equals the input. The use of nonlinear transfer functions is
achieve the desired output result for given one of the distinguishing features of neural networks.
random walk time series are of interest in test of randomness within financial time
providing a theoretical framework for series is fraught with problems and even
financial time series and provides an the most advanced nonlinear models, still
applicable framework for neural networks have not devised efficient ways to model
in finance. Equation 3 below presents the the behavior of financial time series.
random time series, which is used to Based on the analysis above, the neural
model market prices. network seems like an appropriate model
to analyze financial time series, since it
pt = pt-1 + ut will provide insight into the nature of the
relationship between time series data
Equation 3 (which can be useful for forecasting and
stock market analysis which is examined
Where p represents market prices, the ts below).
subscripts are an index of time, and u is a Figure 3 below shows, since the
stochastic variable, which is identically hypothesis being tested and debated in
distributed. That is, u~(0, c). finance is whether financial time series
Typically, the random walk theory is have information that can be useful for
applied to stock market analysis and is a predictive purposes, or just happen to
useful background to the question of the follow a random walk. Neural networks
nature of financial time series (‘Financial have been useful in testing this hypothesis.
Time Series as Random Walk” 6). Direct
Figure 3: Stock Market Data from the New York Stock Exchange for Newmont
Mining: Random Walk?
process. What
W is cleear is that there is a diverrsification; it is measuured by the beta
direct linkk between capital
c budggeting and coeffficient.
stock valuees. The morre effective the firm’s With
W the cost
c of eequity equation
capital buddgeting proccedures, thee higher its analyyzed in previous secttions, it iss not
stock pricee. These arre hypothesees that are surprrising that as
a market rissk increasess, the
also tested via neural networks.
n cost of equity increases aand stock valuev
Once a potentiall capital budgeting falls.. Calculaated risk ccoefficients and
project hass been idenntified, its evaluation
e interactions withh other variiables in fin
nance
involves thhe same stteps that arre used in can also be approximatted via neural
security annalysis. Deecision rulees can be netwworks.
summarizeed by the faact that if thhe present Generally,
G thhese appliccations rely
y on
value of thhe cash floows exceedds the cost the fact
f that neuural networkk models caan be
the projecct is acceepted. Otheerwise, it used to devvise a ffunction from
should be rejected. (Alternative
( ely, if the obserrvations (thhat may orr may not have
expected rate of retturn on thhe project existted before). This is ussually within n the
exceeds itss cost of capital,
c the project is finannce field whhere data is too compleex to
accepted). With this similarity, it is also analyyze (Smith para 6). Specifically y the
relatively easy
e to usee neural nettworks for use of artificiaal intelligennce techniq ques,
forecastingg and arrivving at rellationships whicch is generaalized in figgure 4 belo ow is
and estimaates betweenn the variables. used within the financial inndustry with h the
Risk annalysis is beest approxim mated with latestt methodoloogical approoaches aimed at
market riskk, that is, thhe part of a project’s mainntaining the competitivee edge.
risk that cannot be eliminnated by
(
(Inclusive o Capital Budgeting
of B and Risk Analysis)
A
*Exttracted from
m Leslie Smiith, Centre for
f Cognitivve and Com
mputational N nce
Neuroscien
Wallace M.P
P. - Neural Netwoorks and Their Ap
pplication to Finaance
2008 Martin P. Wallace 75
and restrictive; however, this does not 2000, 81-98. Retrieved on March 5, 2007
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results, irrespective of the complexity of pdf/2000/01/verleyse.pdf?access=ok
the methodology used.
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