Information-Theoretic Approach to Financial Market Modelling

Abstract

The paper treats the financial market as a communication system, using four information-theoretic assumptions to derive an idealized model with only one parameter. State variables are scalar stationary diffusions. The model minimizes the surprisal of the market and the Kullback-Leibler divergence between the benchmark-neutral pricing measure and the real-world probability measure. The state variables, their sums, and the growth optimal portfolio of the stocks evolve as squared radial Ornstein-Uhlenbeck processes in respective activity times.