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"barbell" construction.5
The Barbell as seen by E.T. Jaynes
Our approach to constrain only what can be constrained
(in a robust manner) and to maximize entropy elsewhere
echoes a remarkable insight by E.T. Jaynes in "How
should we use entropy in economics?" [12]:
It may be that a macroeconomic system does
not move in response to (or at least not solely
in response to) the forces that are supposed to
exist in current theories; it may simply move
in the direction of increasing entropy as constrained by the conservation laws imposed by
Nature and Government.
R EVISITING
THE
m
X
w i Xi ,
i=1
V (X) = w
~ w
~T .
0.4
0.3
Area
0.2
0.1
-4
-2
Returns
R EVISITING
THE
G AUSSIAN C ASE
1
1
()2
(()) = p
exp{
}.
()
2
2()
f (x) dx = .
1
E(X|X K) = .
Assuming 1) holds, constraint 2) is equivalent to
Z K
E(XI(XK) ) =
xf (x) dx = .
1
+ KB()
,
1 + B()
K
.
()(1 + B())
1.
()B() = .
Consider the conditions under which the VaR constraints allow a positive mean return = E(X) > 0. First,
from the above linear equation in and in terms of
() and K, we see that increases as increases for any
K
fixed mean , and that > 0 if and only if > ()
, i.e.,
we must accept a lower bound on the variance which
increases with , which is a reasonable property. Second,
Probability
2
1)
+ (1
)N (2 ,
2
2 ).
Ret
M AXIMUM E NTROPY
m)2 +s2
)f2 )
h(f1 ) + (1
)h(f2 ).
We want to maximize entropy subject to the VaR constraints together with any others we might impose.
Indeed, the VaR constraints alone do not admit an MEE
since they do not restrict the density f (x) for x > K.
The entropy can be made arbitrarily large by allowing f
to be identically C = N1 K
over K < x < N and letting
N ! 1. Suppose, however, that we have adjoined one
or more constraints on the behavior of f which are
compatible with the VaR constraints in the sense that the
set of densities satisfying all the constraints is nonempty. Here would depend on the VaR parameters
= (K, , ) together with those parameters associated
with the additional constraints. The MEE is then defined
as
Perturbating
0.4
0.1
0.25
0.2
f (x) =
and
f+ (x) =
8
<
1
(K )
exp
:0
8
<
:0
K) exp
x K
+ K
20
if x < K,
if x
0.5
K.
if x > K,
0.3
if x K.
0.2
and f+ integrate to
0.1
)f+ (x)
fM EE (x) = C 1 exp
1 x + 2 I(xK) + 3 xI(xK)
where C = C( 1 , 2 , 3 ) is the normalizing constant.
(This form comes from differentiating an appropriate
functional J(f ) based on entropy, and forcing the integral to be unity and imposing the constraints with
Lagrange multipliers.)
The shape of f depends on the relationship between
K and the expected shortfall . The closer is to
K, the more rapidly the tail falls off. As ! K, f
converges to a unit spike at x = K.
4.2
10
-10
0.4
1
(+
K x
K
0.5
0.1
-20
)+ = .
h
0.
0.3
-10
-5
10
on the
f+ (x) =
Then
8
<
2 exp(
1 K)
exp(
:0
1 |x|)
if x
K,
if x < K.
4.3
1
(1 + |x|)
C()
(1+)
,x
Perturbating
1.5
K,
K
It follows that A and satisfy the equation
1
A=
1.0
2
5
2
0.5
-2
-1
log(1 K)
.
2(1 K) 1
0.5
0.4
Perturbating
0.3
1.5
0.2
1
1.0
0.1
3
2
2
-4
0.5
-2
-1
1
K x
fM EE (x) = I(xK)
exp
(K )
K
(1 + |x|) (1+)
+ (1 )I(x>K)
.
C()
Extension to a Multi-Period Setting: A Comment
10
(t) =
lim
n!1
4.4
-2
(t/n)n = eit(+ +(
+ ))
(1)
C OMMENTS
AND
C ONCLUSION
We note that the stop loss plays a larger role in determining the stochastic properties than the portfolio composition. Simply, the stop is not triggered by individual
components, but by variations in the total portfolio. This
frees the analysis from focusing on individual portfolio
components when the tail via derivatives or organic
construction is all we know and can control.
To conclude, most papers dealing with entropy in the
mathematical finance literature have used minimization
of entropy as an optimization criterion. For instance,
Fritelli (2000) [20] exhibits the unicity of a "minimal
entropy martingale measure" under some conditions and
shows that minimization of entropy is equivalent to
maximizing the expected exponential utility of terminal
wealth. We have, instead, and outside any utility criterion, proposed entropy maximization as the recognition
of the uncertainty of asset distributions. Under VaR
and Expected Shortfall constraints, we obtain in full
generality a "barbell portfolio" as the optimal solution,
extending to a very general setting the approach of the
two-fund separation theorem.
R EFERENCES
[1]
[2]
[3]
[4]
[5]
[6]
[7]
[8]
[9]
[10]
[11]
[12]
[13]
[14]
[15]
[16] M. Richardson and T. Smith, A direct test of the mixture of distributions hypothesis: Measuring the daily flow of information,
Journal of Financial and Quantitative Analysis, vol. 29, no. 01, pp.
101116, 1994.
[17] T. An and H. Geman, Order flow, transaction clock, and normality of asset returns, The Journal of Finance, vol. 55, no. 5, pp.
22592284, 2000.
[18] N. N. Taleb, Dynamic Hedging: Managing Vanilla and Exotic Options.
John Wiley & Sons (Wiley Series in Financial Engineering), 1997.
[19] D. Brigo and F. Mercurio, Lognormal-mixture dynamics and
calibration to market volatility smiles, International Journal of
Theoretical and Applied Finance, vol. 5, no. 04, pp. 427446, 2002.
[20] M. Frittelli, The minimal entropy martingale measure and the
valuation problem in incomplete markets, Mathematical finance,
vol. 10, no. 1, pp. 3952, 2000.
A PPENDIX
Proof of Proposition 1: Since X N (,
probability constraint is
= P(X < K) = P(Z <
By definition,
)=
), the tail
).
(()) = . Hence,
(2)
K = + ()
For the shortfall constraint,
Z K
x
(x )2
p
E(X; X < k) =
exp
dx
2 2
2
1
Z (K )/ )
= +
x (x) dx
1
exp
(K )2
2 2
()B()
(3)