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About this paper
Eckhard Platen
This paper presents an information-theoretic framework to financial market modeling, deriving a parsimonious "Minimal Market Model" that endogenously explains seven key empirical stylized facts of financial markets. The model also formalizes benchmark-neutral pricing, which provides minimal prices for replicable contingent claims without requiring estimation of the net risk-adjusted return, yielding hedge errors below 0.0001 for long-maturity zero-coupon bonds.
Key insights
- Minimizing surprisal and Kullback-Leibler divergence leads to normalized factors evolving as Cox-Ingersoll-Ross (CIR) processes and reveals that the market's benchmark follows a Squared Radial Ornstein-Uhlenbeck (SROU) process of dimension four.
- The derived Minimal Market Model (MMM) naturally and endogenously explains seven well-documented stylized empirical facts of financial markets, including Student-t distributed log-returns with four degrees of freedom, the leverage effect, and volatility clustering.
- Benchmark-neutral pricing, by utilizing the benchmark as numéraire, simplifies practical application by eliminating the need to estimate the net risk-adjusted return, while yielding theoretically minimal prices and facilitating accurate hedging strategies.
Summary by alphaXiv.
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