Entropy Analysis of Financial Time Series

Stephan Schwill

Research output: ThesisDoctoral Thesis

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This thesis applies entropy as a model independent measure to address research ques- tions concerning the dynamics of various financial time series. The thesis consists of three main studies as presented in chapters 3, 4 and 5. Chapters 3 and 4 apply an entropy measure to conduct a bivariate analysis of drawdowns and drawups in foreign exchange rates. Chapter 5 investigates the dynamics of investment strategies of hedge funds using entropy of realised volatility in a conditioning model.In all three studies, methods from information theory are applied in novel ways to financial time series. As Information Theory and its central concept of entropy are not widely used in the economic sciences, a methodology chapter was therefore included in chapter 2 that gives an overview on the theoretical background and statistical features of the entropy measures used in the three main studies. In the first two studies the focus is on mutual information and transfer entropy. Both measures are used to identify dependencies between two exchange rates. The chosen measures generalise, in a well defined manner, correlation and Granger causality. A di↵erent entropy measure, the approximate entropy, is used in the third study to analyse the serial structure of S&P realised volatility.The study of drawdowns and drawups has so far been concentrated on their uni- variate characteristics. Encoding the drawdown information of a time series into a time series of discrete values, Chapter 3 uses entropy measures to analyse the corre- lation and cross correlations of drawdowns and drawups. The method to encode the drawdown information is explained and applied to daily and hourly EUR/USD and GBP/USD exchange rates from 2001 to 2012. For the daily series, we find evidence of dependence among the largest draws (i.e. 5% and 95% quantiles), but it is not as strong as the correlation between the daily returns of the same pair of FX rates. There is also dependence between lead/lagged values of these draws. Similar and stronger findings were found among the hourly data. We further use transfer entropy to examine the spill over and lead-lag information flow between drawup/drawdown of the two exchange rates. Such information flow is indeed detectable in both daily and hourly data. The amount of information transferred is considerably higher for the hourly than the daily data. Both daily and hourly series show clear evidence of information flowing from EUR/USD to GBP/USD and, slightly stronger, in the reverse direction. Robustness tests, using e↵ective transfer entropy, show that the information measured is not due to noise.Chapter 4 uses state space models of volatility to investigate volatility spill overs between exchange rates. Our use of entropy related measures in the investigationof dependencies of two state space series is novel. A set of five daily exchange rates from emerging and developed economies against the dollar over the period 1999 to 2012 is used. We find that among the currency pairs, the co-movement of EUR/USD and CHF/USD volatility states show the strongest observed relationship. With the use of transfer entropy, we find evidence for information flows between the volatility state series of AUD, CAD and BRL.Chapter 5 uses the entropy of S&P realised volatility in detecting changes of volatility regime in order to re-examine the theme of market volatility timing of hedge funds. A one-factor model is used, conditioned on information about the entropy of market volatility, to measure the dynamic of hedge funds equity exposure. On a cross section of around 2500 hedge funds with a focus on the US equity markets we find that, over the period from 2000 to 2014, hedge funds adjust their exposure dynamically in response to changes in volatility regime. This adds to the literature on the volatility timing behaviour of hedge fund manager, but using entropy as a model independent measure of volatility regime. Finally, chapter 6 summarises and concludes with some suggestions for future research.
Original languageEnglish
Awarding Institution
Publication statusPublished - 18 Jun 2015


  • Finance, Risk Management, Time Series Analysis, Econometrics, Information Theory, Entropy


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