Wednesday, March 31, 2010


In some earlier posts I discussed dissipative systems and entropy. For purposes of this post I will use the interaction of two open and dissipative systems, the US bond market (10 year notes) and the US stock market (SPY). In addition, I am making some assumptions. The first is that I like to think of entropy in the markets as equivalent to the amount of information and uncertainty that exists. The second is that higher standard deviation is equivalent to higher entropy. A higher standard deviation means prices are more variable and erratic. This is a result of more uncertainty, and consequently, more entropy in the market. In addition, this can also be thought of in reverse--less risk leads to less uncertainty, and consequently, less entropy.

In general, standard deviation is used as a measure of volatility in a market. Markets become more volatile as the level of uncertainty grows. I have created two graphs which show the standard deviation of both markets since the beginning of 2007. One graph shows that if the relative volatility is greater than 1, then stock prices have a higher level of entropy compared to bond prices. If less than 1, then bond prices have more entropy than stock prices. The second graph shows the actual standard deviation of each market. Two quick conclusions can be made from these charts. The first is that volatility has significantly declined in both markets since the height of the financial crises, and second, the volatility in bonds is higher relative to stocks. More next time…

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