Machine learning models in finance

Introduction and background

There has been interest in developing computer algorithms that improve automatically through experience (“machine learning”) for many decades. The term “machine learning” (ML) was popularized in 1959 by Arthur Lee Samuel[1], a pioneer in computer gaming and artificial intelligence who first developed a program able to improve its performance[2] playing checkers, which defeated a human player in 1962 running on an IBM 7094[3], one of the first commercially available computers.

Arthur L. Samuel using an IBM 7094

Arthur L. Samuel using an IBM 7094.

 
Research on ML algorithms, and the increasing available computer power, has allowed addressing more complex problems, breaking milestones of performance on tasks that were once deemed either too complex or simply out of reach for non-human “intelligent” systems.

In the past two decades, IBM’s DeepBlue defeated in 1997 the then world chess champion Garri Kasparov, using a program which performed over 200 million calculations per second, a brute force approach instead of a machine learning algorithm[4]. Nevertheless, outperforming human intelligence at a complex task was an important milestone for a computer program, and in the following years other ML programs mastered other complex tasks that previously seemed out of reach for non-human intelligent systems.

Watson, a natural language question-answering computer system developed by IBM won at Jeopardy in 2011[5]; ChefWatson, developed on 2013 by IBM, was able to propose new recipes out of a list of ingredients and cuisine style[6]; AlphaGo, a program that plays Go developed by DeepMind defeated in 2016 the then world Go champion Lee Sedol[7]; AlphaFold and AlphaFold2 protein 3D structure prediction programs developed by DeepMind gave outstanding predictions on the past two CASP challenges[8] (Critical Assessment of protein Structure Prediction, a biannual challenge where participants provide 3D protein structure for known but undisclosed target proteins). It’s noteworthy that most of these achievements were made by deep neural networks, a type of ML model.

AlphaFold and AlphaFold2 protein 3D structure predictions in the past two CASP challenges were head and shoulders better than those of any past challenge.

AlphaFold and AlphaFold2 protein 3D structure predictions in the past two CASP challenges were head and shoulders better than those of any past challenge.

 
Over the years, ML programs have been applied to a wide diversity of tasks in different fields, for example in medicine[9], drug discovery[10], machine translation[11], automatic speech recognition [12], autonomous vehicle control[13,14], marketing [15], video surveillance[16], shipping[17] and finance[18].

Given these many different fields of application and the ultimate goal, shared by human researchers and ML algorithms, to improve through experience, it’s expected that many different techniques have been developed and tried over time. Also, the “no free lunch” theorem, which states that no algorithm outperforms another algorithm in all possible application domains[19], guarantees that the ML toolkit can only grow with time.
Despite the different fields where ML methodologies are applied, they share some common traits. All ML models have parameters which control the performance of the model, and hyperparameters that affect the learning process and how generalizable is the model. They are built following a common iterative process.

First, the algorithm is exposed to the training dataset, and the parameters of the model are optimized so that the algorithm produces the best quality output for the training dataset. Then its performance doing the task is assessed with a different dataset (the test dataset), and in a final step the hyperparameters of the algorithm are adjusted to make it as generalizable as possible to unseen data. The cycle starts over when the need arises to improve the model and more training data becomes available, the later doesn’t take long given the pace at which new data is generated[20].

ML model lifecycle

ML model lifecycle.

 
ML methods can be classified in three different broad categories according to how they learn from the training dataset: supervised learning, unsupervised learning and reinforcement learning. Supervised and unsupervised learning optimize one single task, whereas reinforcement learning optimizes a particular type of task, finding the optimal action to choose at every step in a sequence.

In supervised learning algorithms the training data contains both the features to be trained upon as well as the expected outcome for every example. In unsupervised learning the training dataset contains only features, the expected outcome is not explicitly provided. Reinforcement learning algorithms are exposed to a sequential training dataset and to the action taken at each step.

ML methods classification

ML methods classification.

 
According to the output produced by each algorithm, supervised learning techniques can further be classified into regression or classification tasks, where the former produce a number and the later a category. Unsupervised learning could be subdivided into clustering tasks, which produce a partition of data into groups, and representation learning algorithms, which map complex data into a lower dimensional space simpler to understand and analyze. Reinforcement learning is further divided into policy function algorithms, which choose the optimal action to be taken at every step, and reward function learning, that find the reward value which justifies the actions observed at each step.

Researchers have developed many algorithms in each category, ranging in complexity from the simple linear regression to the complex representation learning algorithms, but artificial neural networks[21] are particularly interesting as they have been involved in many of the recent groundbreaking successes of ML. Artificial neural networks were first proposed in 1943[22], and comprise a set of nodes grouped in layers. Nodes in the first hidden layer take the input values and perform a weighted sum (a linear transformation) over the input values, and then a non-linear operation on the result to produce an output value which is propagated forward to the nodes of the second hidden layer, who perform the linear transformation and non-linear operation, and so on until the last hidden layer produces the final output values.

By Glosser.ca - Own work, Derivative of File:Artificial neural network.svg, CC BY-SA 3.0, https://commons.wikimedia.org/w/index.php?curid=24913461

By Glosser.ca - Own work, Derivative of File: Artificial neural network.svg, CC BY-SA 3.0, link

 
There are many types of neural networks, differing not only in the number of hidden layers or nodes in each layer, but also in the operations performed on the input or how the input is connected to the nodes. Forward fully connected (FNN) are a type of networks where all the input values are connected to every node. Convolutional (CNN) networks preprocess the input before passing the outcome to a fully connected network. Recurrent (RNN) and long short-term memory (LSTM) networks, both used for sequential input, “remember” the input from previous steps to provide an output in the current step.

Despite the different types of neural networks, their training with a training dataset involves computing a “loss” or “cost” value from its output, and then adjusting the network parameters to lower the value of the loss. In a supervised learning neural network, the loss function could be the root mean square difference between the expected and observed output, whereas for reinforcement learning the loss could be a function of a calculated reward. Then, a backpropagation algorithm[25] is used to find out how to adjust the weights in each layer to minimize the loss function value.

The term “deep” neural network is applied to those networks having more than one “hidden” layer, and it has been shown that multilayered forward networks can approximate functions to any desired precision[23,24]. This explains why they have been successfully applied to learn all sorts of supervised learning[26,27], unsupervised learning[28,29,30,31] and reinforcement learning tasks[32,33].

Machine learning models in finance

The applications of ML algorithms in the field of finance might be classified into models used for tasks in banking, asset management or trading. Banks are interested in analyzing data generated by their customers, their financial transactions or the reports filed by companies in order to target marketing campaigns, or assess credit default risk, or detect fraud. Fund managers are interested in tasks like optimizing their portfolios to maximize returns and control risk, detect market regime changes and understand correlations amongst assets. Trading tasks include price prediction, market impact and liquidity assessment and algorithmic trading.
 

Banking Asset Management Trading
  • Customer segmentation [34]
  • Regime change detection [42]
  • Trading execution [46]
  • Loan, credit defaults [35]
  • Stock segmentation
  • Market impact assessment [47]
  • Fraud detection [36]
  • Factor modeling [43]
  • Price prediction [48]
  • Client data mining [37]
  • Portfolio optimization [44]
  • Earning/returns prediction [49]
  • Money laundering detection[ 38]
  • Derivatives trading (valuation) [45]
  • Algorithmic trading [50]
  • Rating prediction [39, 40]
  • Optimal market making [51]
  • Recommender systems [41]
  • ML applications in finance.
     
     
    A review of recently published deep learning networks applied in finance and banking showed that 53% of these ML models were applied to price prediction of stock, currency exchange rates or oil. Another 26% were applied to stock trading, 11% to banking tasks like default risk prediction and credit assessment, and the remaining 10% in portfolio management and prediction of macroeconomic variables. If we classify tasks into banking, asset management and trading, trading tasks represent ~79% (53% in price prediction plus 26% in stock trading) of recently published deep learning networks[52].

    The high number of studies on price prediction (53%) is caused by the complexity of financial time series, which sometimes are non-linear, non-stationary, and show interdependencies. Models of financial time series have evolved with time, traditional methods like autoregressive integrated moving average (ARIMA) and generalized autoregressive conditional heteroskedasticity (GARCH) gave way to ML models, better able to cope with non-linearities, like random forests (RF), support vector machines (SVM), support vector regression (SVR) and deep learning (DL)[53]. Recently, some hybrid models that combine traditional methods with ML, as well as reinforcement learning (RL) models, have improved the accuracy of earlier prediction models [53].

    Another review of published ML models in finance classifies them in (see figure below) single DL, hybrid DL, hybrid ML (excluding DL) and ensembles of methods (a set of models where the final outcome is a function of every individual outcome of each model in the ensemble). The most frequent goal in each category was found to be price prediction[54]. Given the interest of ML researchers in the area of trading, it’s likely that future advances in RL and DL networks will soon be adapted to price prediction and other related tasks in the area of trading.

    Taxonomy of machine learning models[54]

     
     

    Guillem Plasencia

    Senior Software Developer & Data Scientist,
    Adaptive Financial Consulting Ltd

     
     


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