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Entropy is something that measures randomness. The term is similar to infinity and analyzes how unpredictable a random variable can be. Financial experts use this term for knowing the probability of a particular type of behavior that a specific stock, security, or a market exhibits.
Several market analysts and researchers have debated over the significance of entropy. It is applicable in conducting the quantitative analysis, and further enables to ascertain if a security would follow a specific trend or pattern. The more volatile the securities are, the higher the entropy will be. One can have an in-depth knowledge about this concept of entropy in ‘A Random Walk Down Wall Street’.
A Little More on What is Entropy
In the financial industry, entropy is considered for ascertaining the monetary risk. Every investment carries risk, be it high or less. As per the assumptions, the more risky the investment is, the higher profits will be. Therefore, investors who are tempted towards more and steady growth invest in stocks that are highly volatile. In terms of entropy, if a stock carries more entropy, then it will be considered to carry more risk than other stocks. There are many financial analysts who believe that entropy helps in getting a better idea about risks than beta. Similar to beta, entropy decreases with the addition of more assets and securities in a given portfolio.
It is the calculation that makes it difficult for entropy to be used on a large scale. Several theories discussing the right application of entropy in the finance industry exist. For instance, entropy measures and identifies risks associated with financial derivatives, and further offers ways to reduce risks. The conventional CAPM or capital asset pricing model is based on the assumption that it is possible to hedge every type of risk, meaning that risks are possible to be measured and controlled. A random variable signifies entropy so as to nullify the randomness offered by the underlying asset or security. This further enables the financial expert to isolate the derivative’s price. Entropy helps in ascertaining the most feasible variable that can further help in assessing the risk levels involved in a particular system. The most feasible variable deviates the minimum from actuality. Financial experts usually use expected values and probabilities for representing such variables. They tend to seek a more effective method for arriving at prices of complicated financial instruments.