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A Thermodynamic Picture of Financial Market and Model Risk

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  • Yu Feng

Abstract

By treating the financial market as a thermodynamic system, we establish a one-to-one correspondence between thermodynamic variables and economic quantities. Measured by the expected loss under the worst-case scenario, financial risk caused by model uncertainty is regarded as a result of the interaction between financial market and external information sources. This forms a thermodynamic picture in which a closed system interacts with an external reservoir, reaching its equilibrium at the worst-case scenario. The severity of the worst-case scenario depends on the rate of heat dissipation, caused by information sources reducing the entropy of the system. This thermodynamic picture leads to simple and natural derivation of the characterization rules of the worst-case risk, and gives its Lagrangian and Hamiltonian forms. With its help financial practitioners may evaluate risks utilizing both equilibrium and non-equilibrium thermodynamics.

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  • Yu Feng, 2019. "A Thermodynamic Picture of Financial Market and Model Risk," Papers 1904.00151, arXiv.org.
    • Handle: RePEc:arx:papers:1904.00151
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    References listed on IDEAS

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    1. Yu Feng, 2019. "Non-Parametric Robust Model Risk Measurement with Path-Dependent Loss Functions," Papers 1903.00590, arXiv.org.
    2. Yuhong Xu, 2014. "Robust valuation and risk measurement under model uncertainty," Papers 1407.8024, arXiv.org.
    3. Paul Glasserman & Xingbo Xu, 2014. "Robust risk measurement and model risk," Quantitative Finance, Taylor & Francis Journals, vol. 14(1), pages 29-58, January.
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