Entropy-based modelling financial asset return

Abstract

Purpose: investigation of mechanisms and methods of modelling financial as-set return based on entropy risk measures. Discussion: Entropy explains the return both securities and portfolios in a simpler way and, at the same time, with higher explanatory power than the beta of the capital asset pricing model. For asset pricing we define the continuous entropy as an alternative risk meas-ure. Results: our results show that entropy decreases in the function of the number of securities involved in a portfolio in a similar way to the standard deviation, and that efficient portfolios are situated on a hyperbola in the ex-pected “return – entropy” system. Entropy as a novel risk measure combines the advantages of the CAPM’s risk parameter (beta) and the standard devia-tion. It captures risk without using any information about the market, and it is capable of measuring the risk reduction effect of diversification.