Toward a Theory of Marginally Efficient Markets

Details Toward a Theory of Marginally Efficient Markets Toward a Theory of Marginally Efficient Markets

1999-01-22

arxiv.org/abs/cond-mat/9901243v1

Physics

Condensed Matter

Statistical Mechanics

9 pages, 3 ps figures

Scientific paper

10.1016/S0378-4371(99)00077-1

Empirical evidence suggests that even the most competitive markets are not strictly efficient. Price histories can be used to predict near future returns with a probability better than random chance. Many markets can be considered as {\it favorable games}, in the sense that there is a small probabilistic edge that smart speculators can exploit. We propose to identify this probability using conditional entropy concept. A perfect random walk has this entropy maximized, and departure from the maximal value represents a price history's predictability. We propose that market participants should be divided into two categories: producers and speculators. The former provides the negative entropy into the price, upon which the latter feed. We show that the residual negative entropy can never be arbitraged away: infinite arbitrage capital is needed to make the price a perfect random walk.

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