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Energy, entropy, and arbitrage

  • Soumik Pal
  • Ting-Kam Leonard Wong
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    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.

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    File URL: http://arxiv.org/pdf/1308.5376
    File Function: Latest version
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    Paper provided by arXiv.org in its series Papers with number 1308.5376.

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    Date of creation: Aug 2013
    Date of revision: Jan 2016
    Handle: RePEc:arx:papers:1308.5376
    Contact details of provider: Web page: http://arxiv.org/

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    1. Daniel Kuhn & David Luenberger, 2010. "Analysis of the rebalancing frequency in log-optimal portfolio selection," Quantitative Finance, Taylor & Francis Journals, vol. 10(2), pages 221-234.
    2. Robert Fernholz & Ioannis Karatzas, 2005. "Relative arbitrage in volatility-stabilized markets," Annals of Finance, Springer, vol. 1(2), pages 149-177, November.
    3. Eckhard Platen & Renata Rendek, 2010. "Approximating the Numeraire Portfolio by Naive Diversification," Research Paper Series 281, Quantitative Finance Research Centre, University of Technology, Sydney.
    4. Thomas M. Cover, 1991. "Universal Portfolios," Mathematical Finance, Wiley Blackwell, vol. 1(1), pages 1-29.
    5. Robert Fernholz & Ioannis Karatzas & Constantinos Kardaras, 2005. "Diversity and relative arbitrage in equity markets," Finance and Stochastics, Springer, vol. 9(1), pages 1-27, January.
    6. Fernholz, Robert & Shay, Brian, 1982. " Stochastic Portfolio Theory and Stock Market Equilibrium," Journal of Finance, American Finance Association, vol. 37(2), pages 615-24, May.
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