entropy based asset pricing
TRANSCRIPT
Mihály Ormos and Dávid Zibriczky
Department of FinanceBudapest University of Technology and Economics
5th international ECEE series conference "Economic Challenges in Enlarged Europe„
Tallinn, Estonia, June 16-18, 2013
Risk vs. expected return (risk premium)
Standard deviation (Markowitz, 1952)
Assumes normal distribution
CAPM beta (Sharpe, 1964)
Requires market portfolio
Assumes linearity
Measures systematic risk only
Problems:
Assumptions
Low explanatory power
Alternative single risk measure?
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mathematically-defined quantity that is generally used for characterizing the probability of outcomes in a system through a process
Main applications:
Thermodynamics: Clausius (1867) – distribution of inner energy
Statistical Mechanics: Boltzmann (1872) – molecular disorder
Information Theory: Shannon (1948) – message compression
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Generalized discrete formula: 𝐻𝛼 𝑋 =1
1−𝛼log 𝑖 𝑝𝑖
𝛼
𝑝𝑖: probability of discrete outcome Xi
Special cases 𝛼 = 1: Shannon entropy (L'Hôpital's rule)
𝛼 = 2: Rényi entropy
Problem: Value of return is continuous, discrete formula cannot be applied
Continuous formula: 𝐻𝛼 𝑋 =1
1−𝛼ln 𝑓 𝑥 𝛼𝑑𝑥 (differential entropy)
𝑓 𝑥 :probability function
𝑓 𝑥 = ?
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Density estimation: 𝑓𝑛 𝑥 ~ 𝑓 𝑥
Methods
Histogram (fixed bin width)
Kernel density estimation (sum of core weights)
Sample spacing (fixed number of elements in one bin)
Histogram Kernel Sample spacing
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Original formula: 𝐻𝛼 𝑋 =1
1−𝛼ln 𝑓 𝑥 𝛼𝑑𝑥
Entropy estimation in single formula using histogram*:
Shannon entropy: 𝐻1,𝑛 𝑋 = −1
𝑛 𝑗 𝑣𝑗 ln
𝑣𝑗
𝑛ℎ
Rényi entropy: 𝐻2,𝑛 𝑋 = −ln 𝑗 ℎ𝑣𝑗
𝑛ℎ
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Entropy risk measure**: 𝜿𝑯𝜶𝑺𝒊 = 𝒆
𝑯𝜶,𝒏 𝑹𝒊−𝑹𝑭
* 𝑣𝑗: number of elements falling into the jth bin, h: bin size
** 𝜿: risk measure, 𝑺𝒊: Security i, 𝑹𝒊 − 𝑹𝑭: Risk premium6
Standard deviation (Markovitz):
𝜿𝝈 𝑺𝒊 = 𝝈 𝑹𝒊 − 𝑹𝑭
Beta (CAPM):
𝜿𝜷 𝑺𝒊 =𝐜𝐨𝐯 𝑹𝒊−𝑹𝑭,𝑹𝑴−𝑹𝑭
𝝈𝟐 𝑹𝑴−𝑹𝑭
Shannon entropy:
𝜿𝑯𝟏𝑺𝒊 = 𝒆
𝑯𝟏 𝑹𝒊−𝑹𝑭
Rényi entropy:
𝜿𝑯𝟐𝑺𝒊 = 𝒆
𝑯𝟐 𝑹𝒊−𝑹𝑭
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Source: The Center for Research in Security Prices (CRSP)
Series: Daily return
Market return (value weighted)
Risk free rate (1-month T-bill)
150, randomly selected securities from the components of S&P500 index
Period: 1985-2011 (27 years or 6810 days)
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0
1
2
3
4
5
6
7
8
1 10 100
Averag
e r
isk
Number of securities in portfolio
Shannon Rényi StDev
0%
10%
20%
30%
40%
50%
1 10 100
Averag
e r
isk r
ed
ucti
on
Number of securities in portfolio
Shannon Rényi StDev
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-0,02
0
0,02
0,04
0,06
0,08
0,1
0 2,5 5 7,5 10 12,5 15
E(r
p-r
F)
Risk (H1)
Shannon entropy
n=1
n=2
n=5
n=10
10
-0,02
0
0,02
0,04
0,06
0,08
0,1
0 2,5 5 7,5 10 12,5 15
E(r
p-r
F)
Risk (H1)
Shannon entropy
n=1
n=2
n=5
n=10
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Evaluation method
Long term (1985-2011), for 150 random securities
Explanatory variable (X): Risk
Target variable (Y): Expected risk premium
Linear regression (X,Y)
Explanatory power: Goodness of fit of regression line (R2)
Result
Higher explanatory power
Risk measure R2 long
Standard deviation 7.83%Beta 6.17%Shannon entropy 12.98%
Rényi entropy 15.71%
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-0,02
0
0,02
0,04
0,06
0,08
0,1
0,12
0,14
0 1 2 3 4 5
E(r
i-r
F)
Risk (std)
Standard deviation
E(ri-rF) = 0.0170 + 0.0085*std
R² = 7.83%
-0,02
0
0,02
0,04
0,06
0,08
0,1
0,12
0,14
0 0,5 1 1,5 2
E(r
i-r
F)
Risk (beta)
Beta
E(ri-rF) = 0.0209 + 0.0151*beta
R² = 6.17%
-0,02
0
0,02
0,04
0,06
0,08
0,1
0,12
0,14
0 2,5 5 7,5 10 12,5 15
E(r
i-r
F)
Risk (H1)
Shannon entropy
E(ri-rF) = 0.0091 + 0.0034*H1
R² = 12.98%
-0,02
0
0,02
0,04
0,06
0,08
0,1
0,12
0,14
0 2,5 5 7,5 10 12,5
E(r
i-r
F)
Risk (H2)
Rényi entropy
E(ri-rF) = 0.0059 + 0.0049*H2
R² = 15.71%
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0
0,05
0,1
0,15
0 10 20 30 40 50 60 70 80 90 100
Exp
lan
ato
ry p
ow
er (
R-s
qu
ared
)
Number of securities in portfolio
StDev Beta Shannon Rényi
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-0,3
-0,2
-0,1
0
0,1
0,2
0 5 10 15 20
E(r
i-r
F)
Risk (H1)
Shannon entropy
bear market
E(ri-rF) = 0.0818 - 0.0150*H1
R² = 0.3961
-0,05
0
0,05
0,1
0,15
0,2
0 5 10 15
E(r
i-r
F)
Risk (H1)
Shannon entropy
bull market
E(ri-rF) = -0.0116 + 0.0103*H1
R² = 0.4345
Risk measure R2 long R2 bull R2 bear
Standard deviation 7.83% 33.9% 36.7%Beta 6.17% 36.7% 43.7%Shannon entropy 12.98% 43.5% 39.6%
Rényi entropy 15.71% 42.4% 38.6%
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Evaluation method
Estimating risk based on a 5-year period (short term)
Predicting average risk premium for the next 5-year period
Applying this on several periods
Predicting power: Average goodness of fit (R2) based on tested periods
Reliability: Standard deviation of R2 values (lower is better)
Result
Better explanatory power for the same first 5 years (R2 short)
Better predicting power for the next 5 years (R2 pred)
Higher reliability (σ)
Risk measure R2 long R2 short R2 pred σ short σ pred
Standard deviation 7.83% 7.94% 9.70% 0.73 0.63Beta 6.17% 13.31% 6.45% 0.95 0.99Shannon entropy 12.98% 13.38% 10.15% 0.67 0.62
Rényi entropy 15.71% 12.82% 9.34% 0.62 0.60
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No assumptions concerning the returns
Entropy estimation doesn’t require an undefined market portfolio
Characterizes specific risk and captures diversification effect
More efficient and reliable risk estimate compared to the standard methods
If the trend is identified entropy based equilibrium model behaves similarly to the
standard models
Thank you for paying attention!
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