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is to study the aperiodic non-linear behaviour emerging from systems sensitive to the initial conditions. Accordingly, the disordered behaviour is a local property of the system, but there are in fact some distinguishable patterns of market behaviour. This is the main insight that this new paradigm gives to finance. It describes markets as having local randomness and global determinism, just as in fractal structures on nature.
Implications of a fractal market for risk management
By adopting Chaos Theory and the Science of Fractals in finance the traditional assumptions of how capital markets behave are modified. For risk management, this would mean a change in the way risk is perceived and how it is controlled. Chaos Theory and the Science of Fractals characterize financial markets as systems sensitive to initial conditions that progress in a non-linear behaviour due to feedback mechanisms. In addition, it conceptualizes agents as having limited cognition capabilities, and most important, behaving irrationally in the market. For risk management this is important because it describes markets not as efficient and stable, but turbulent and volatile. Essentially, it recognizes the risky nature of financial markets. However, today¶s methods to control and price risk are still based on the neoclassical assumptions of normal distributions and Brownian motions. This is probably one of the reasons that explains the failure of risk management systems in times of crisis. In these models, price changes are assumed to move in a smooth and in continuous manner from one value to another and extreme events are just considered far outliers improbable to happen. On the contrary, the objective of fractal tools is to measure the ³roughness´ of the real dynamics of prices. For instance, stable Paretian distributions account for high peaks and fat tails, and multifractals describe volatility clustering, discontinuity and patterns in their models. For this reason, the use of fractal statistics would allow risk managers to comprehend the risky financial motion, and thus, be better prepared when these ³inconvenient´ outliers appear in the market.
- Submitted By Anuradha Hunnur