Information-Theoretic Model for the Growth Optimal Portfolio of Stocks
Eckhard Platen, Kevin Fergusson
Abstract
Drawing on information-theoretic principles and empirical evidence, a proxy for the growth-optimal portfolio of stocks (the benchmark) is constructed and modeled. The derivative of its activity time captures overreactions in trading behavior and follows a fast-moving, quasi-stationary scalar diffusion. The benchmark's log-returns are predicted to follow a Student t distribution with degrees of freedom slightly less than four, and this prediction is tested empirically. With the benchmark as numeraire, the derived model enables benchmark-neutral pricing and hedging.
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