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Hierarchical Clustering

Updated on May 29, 2024
Article byKumar Rahul
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Hierarchical Clustering?

Hierarchical clustering is a data analysis technique used to group financial assets, such as stocks or borrowers, into clusters or nested subgroups based on their similarities. Hierarchical clustering helps financial institutions assess and manage risk by grouping assets or borrowers with similar risk profiles.

Hierarchical Clustering

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This allows for more effective risk mitigation strategies, including diversified portfolio construction and tailored lending practices. Financial institutions leverage hierarchical clustering to enhance credit scoring models. Asset managers use hierarchical clustering to create diversified portfolios. By grouping assets with similar risk-return characteristics, they can construct portfolios that balance risk and return, reducing overall portfolio risk and enhancing investment strategies.

Key Takeaways

  • Hierarchical clustering is a valuable tool for assessing and managing credit and market risk in the financial sector. It helps identify clusters of assets or borrowers with similar risk profiles, facilitating more effective risk mitigation strategies.
  • Hierarchical clustering aids in portfolio diversification by grouping assets with similar risk-return profiles into clusters. This enables asset managers to construct diversified portfolios that balance risk and return, enhancing investment strategies.
  • Financial institutions can use hierarchical clustering to enhance credit scoring models. Grouping borrowers with similar attributes and credit risk profiles, it improves credit default prediction and allows for tailored lending strategies.

Hierarchical Clustering Explained

Hierarchical clustering aims to organize financial assets, such as stocks or bonds, into clusters or nested groupings based on their inherent similarities or relationships. It is a data analysis method rooted in a taxonomy of assets, resembling the evolutionary tree of life in biology. Just as biological taxonomy categorizes species into hierarchical branches, this method classifies financial assets into clusters that exhibit shared characteristics or behaviors.

The origin of hierarchical clustering’s application traces to the mid-20th century, notably to the field of quantitative finance. Early researchers sought ways to categorize and understand the relationships between various financial instruments and assets. Inspired by the hierarchical structures found in biology, they adapted the concept of hierarchical clustering to analyze complex financial datasets.

Today, hierarchical clustering plays a pivotal role in financial risk management, portfolio diversification, credit risk assessment, and market segmentation. By identifying and categorizing assets into hierarchical clusters, financial professionals can gain deeper insights into asset correlations, risk profiles, and market dynamics, aiding in more informed investment decisions and financial strategies.

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Types

Hierarchical clustering encompasses two primary types: agglomerative and divisive, each with distinct characteristics and applications.

  1. Agglomerative Hierarchical Clustering: This is the more common approach. It starts with each data point as an individual cluster and iteratively merges the closest clusters until all data points belong to a single cluster or a specified number of clusters is reached. Agglomerative clustering is intuitive and computationally efficient, making it a popular choice for data exploration, visualization, and analysis. It produces a hierarchical tree structure, or dendrogram, where the leaves represent individual data points, and the branches represent clusters.
  2. Divisive Hierarchical Clustering: This method takes the opposite approach by beginning with all data points in a single cluster and repeatedly subdividing the clusters into smaller, more homogeneous subclusters. Divisive clustering is conceptually more complex and computationally demanding than agglomerative clustering.

Hierarchical clustering can further be classified into different linkage methods that define how the similarity between clusters or data points is measured. Standard linkage methods include single linkage, complete linkage, average linkage, and Ward’s method. These methods impact the shape and interpretation of the dendrogram.

Examples

Let us understand it better with the following examples.

Example #1

Suppose there is a financial data analytics company that specializes in providing insights for investment strategies. They develop a unique and innovative approach using hierarchical clustering to analyze the credit risk of various companies.

In this imaginary scenario, the company collects an extensive dataset containing financial information, credit scores, and market data for numerous corporations. They apply hierarchical clustering to group these companies into clusters based on their credit risk profiles. Each cluster represents companies with similar risk characteristics.

As they explore the hierarchical structure, they notice that some clusters contain primarily high-risk companies with lower credit scores. In contrast, others consist of low-risk companies with solid financials and high credit scores. By understanding this structure, the company can provide valuable insights to investors and financial institutions. They can offer recommendations for constructing diversified portfolios that balance high and low-risk investments.

Example #2

In a groundbreaking study of 2023, unsupervised machine learning techniques have been employed to shed light on the complex dynamics of the HIV epidemic in sub-Saharan Africa. The research, conducted over several years, analyzed a vast data set of over 300,000 respondents from 13 countries in the region.

The objective was to identify clusters of countries sharing common socio-behavioral predictors of HIV. Using an agglomerative hierarchical approach, two principal components were revealed, explaining significant variance in socio-behavioral characteristics among males and females.

Crucially, the study unveiled two distinct clusters for each gender, each sharing critical predictor features. These features encompassed aspects like family relationships, education, circumcision status (for males), employment, urban living, and HIV awareness.

The findings offer a fresh perspective on the HIV epidemic, suggesting that unsupervised machine learning can effectively categorize countries based on socio-behavioral factors, potentially paving the way for more targeted interventions and strategies in the ongoing battle against HIV in sub-Saharan Africa.

Applications

Hierarchical clustering has several applications in the financial world, where it plays a crucial role in risk management, portfolio construction, and market analysis:

  1. Credit Risk Assessment: Financial institutions use it to group borrowers with similar risk profiles. By analyzing historical financial data and credit scores, they can better assess the creditworthiness of individuals or companies. This assists in making more informed lending decisions and setting appropriate interest rates.
  2. Portfolio Diversification: Asset managers employ hierarchical clustering to create diversified portfolios. By categorizing assets with similar price movements or risk profiles into clusters, they can construct portfolios that spread risk more effectively. This approach helps optimize asset allocation to balance risk and return for investors.
  3. Market Segmentation: It is applied to segment financial markets. Analysts can group stocks or sectors with similar market behavior, allowing investors to make strategic decisions based on market trends and dynamics. This segmentation helps traders understand which sectors are more or less correlated, which can impact trading strategies.
  4. Credit Default Prediction: In credit scoring models, hierarchical clustering can be used to group borrowers with similar characteristics, improving credit default prediction models. By identifying subgroups of borrowers, financial institutions can tailor their lending strategies and risk assessments.
  5. Algorithmic Trading: Quantitative traders use such clustering to develop algorithmic trading strategies. It assists in identifying patterns and relationships in financial data, enabling automated trading systems to make data-driven decisions and execute trades at optimal times.
  6. Risk Management: It aids in measuring systemic risk within the financial system. By identifying interconnections and correlations between financial institutions and markets, regulators can monitor and mitigate the impact of financial crises.

Advantages And Disadvantages

The following are the advantages and disadvantages of using hierarchical clustering:

AdvantagesDisadvantages and Challenges
Risk Management: Helps assess and manage credit and market risk.Data Sensitivity: Quality of clustering results depends on data preprocessing and outliers.
Portfolio Diversification: Facilitates the construction of diversified portfolios.Interpretability: Interpretation of dendrograms can be complex.
Credit Scoring: Enhances credit scoring models.Computational Complexity: Resource-intensive, especially with large datasets.
Market Segmentation: Aids in market segmentation and trend analysis.Subjectivity: Decisions about the number of clusters and linkage methods can be subjective.
Algorithmic Trading: Supports quantitative trading strategies.Dimensionality: Struggles with high-dimensional datasets.

Hierarchical Clustering vs K-Means Clustering

Below is a comparison of hierarchical clustering and K-means clustering:

AspectHierarchical ClusteringK-Means Clustering
Clustering MethodHierarchical clustering creates a hierarchy of clusters, which can be represented as a dendrogram.K-means clustering divides data into a predetermined number of non-overlapping clusters.
Cluster Number DeterminationThe number of clusters is not pre-specified and can be determined by cutting the dendrogram at an appropriate level.The number of clusters (k) must be specified before clustering begins.
Cluster ShapeCan handle clusters of various shapes and sizes, making it more flexible in capturing complex data structures.Assumes spherical clusters with similar variance and can perform poorly with non-spherical or irregularly shaped clusters.
Outliers HandlingRobust to outliers because it works with a hierarchical structure where outliers can be isolated in their own branches.Sensitive to outliers, as they can significantly affect cluster centroids.
Data ScalingNot highly sensitive to data scaling, making it suitable for both standardized and non-standardized data.Sensitive to data scaling, as it relies on distances between data points.
InterpretabilityProvides a dendrogram that illustrates the hierarchical structure, offering insight into data relationships at multiple levels.Assigns each data point to a single cluster, making it simpler to interpret but lacking hierarchical insight.

Frequently Asked Questions (FAQs)

1. How does hierarchical clustering assist in risk management?

It assists in risk management by identifying clusters of assets or borrowers with similar risk characteristics. This helps financial institutions assess and manage credit and market risk more effectively and develop strategies to mitigate risks.

2. Can hierarchical clustering handle high-dimensional financial data?

Handling high-dimensional data can be challenging for hierarchical clustering due to the “curse of dimensionality.” It may struggle to provide meaningful results with a high number of attributes, making dimensionality reduction or feature selection necessary.

3. Does hierarchical clustering require the pre-specification of the number of clusters?

No, one advantage of hierarchical clustering is that it does not require the pre-specification of the number of clusters. The number of clusters can be determined by cutting the dendrogram at an appropriate level, making it suitable for scenarios where the optimal number of clusters is unclear.

This article has been a guide to what is Hierarchical Clustering. We explain its examples, comparison with K-means clustering, types, applications, and advantages. You may also find some useful articles here –

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