Risk spillover networks in financial system based on information theory

Since the financial system has illustrated an increasingly prominent characteristic of inextricable connections, information theory is gradually utilized to study the financial system. By collecting the daily data of industry index (2005-2020) and region index (2012-2020) listed in China as samples, this paper applies an innovative measure named partial mutual information on mixed embedding to generate directed networks. Based on the analysis of nonlinear relationships among sectors, this paper realizes the accurate construction of "time-varying" financial network from the perspective of risk spillover. The results are presented as follow: (1) interactions can be better understood through the nonlinear networks among distinct sectors, and sectors in the networks could be classified into different types according to their topological properties connected to risk spillover; (2) in the rising stage, information is transmitted rapidly in the network, so the risk is fast diffused and absorbed; (3) in the declining stage, the network topology is more complex and panic sentiments have long term impact leading to more connections; (4) The US market, Japan market and Hongkong market have significant affect on China's market. The results suggest that this nonlinear measure is an effective approach to develop financial networks and explore the mechanism of risk spillover.