Energy, entropy, and arbitrage

Soumik Pal and Ting-Kam Leonard Wong

Papers from arXiv.org

Abstract: We introduce a pathwise approach to analyze the relative performance of an equity portfolio with respect to a benchmark market portfolio. In this energy-entropy framework, the relative performance is decomposed into three components: a volatility term, a relative entropy term measuring the distance between the portfolio weights and the market capital distribution, and another entropy term that can be controlled by the investor by adopting a suitable rebalancing strategy. This framework leads to a class of portfolio strategies that allows one to outperform, in the long run, a market that is diverse and sufficiently volatile in the sense of stochastic portfolio theory. The framework is illustrated with several empirical examples.

Date: 2013-08, Revised 2016-01
New Economics Papers: this item is included in nep-ene and nep-rmg
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