IDEAS home Printed from https://ideas.repec.org/a/eee/phsmap/v329y2003i1p199-212.html
   My bibliography  Save this article

Thermodynamic analogies in economics and finance: instability of markets

Author

Listed:
  • McCauley, Joseph L.

Abstract

Interest in thermodynamic analogies in economics is older than the idea of von Neumann to look for market entropy in liquidity, advice that was not taken in any thermodynamic analogy presented so far in the literature. In this paper, we go further and use a standard strategy from trading theory to pinpoint why thermodynamic analogies necessarily fail to describe financial markets, in spite of the presence of liquidity as the underlying basis for market entropy. Market liquidity of frequently traded assets does play the role of the ‘heat bath‘, as anticipated by von Neumann, but we are able to identify the no-arbitrage condition geometrically as an assumption of translational and rotational invariance rather than (as finance theorists would claim) an equilibrium condition. We then use the empirical market distribution to introduce an asset's entropy and discuss the underlying reason why real financial markets cannot behave thermodynamically: financial markets are unstable, they do not approach statistical equilibrium, nor are there any available topological invariants on which to base a purely formal statistical mechanics. After discussing financial markets, we finally generalize our result by proposing that the idea of Adam Smith's Invisible Hand is a falsifiable proposition: we suggest how to test nonfinancial markets empirically for the stabilizing action of The Invisible Hand.

Suggested Citation

  • McCauley, Joseph L., 2003. "Thermodynamic analogies in economics and finance: instability of markets," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 329(1), pages 199-212.
    • Handle: RePEc:eee:phsmap:v:329:y:2003:i:1:p:199-212
    DOI: 10.1016/S0378-4371(03)00591-0
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0378437103005910
    Download Restriction: Full text for ScienceDirect subscribers only. Journal offers the option of making the article available online on Science direct for a fee of $3,000
    File URL: https://libkey.io/10.1016/S0378-4371(03)00591-0?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. J.L. McCauley & G.h. Gunaratne, 2002. "An empirical model of volatility of returns and option pricing," Computing in Economics and Finance 2002 186, Society for Computational Economics.
    2. Leonard I. Nakamura, 2000. "Economics and the new economy: the invisible hand meets creative destruction," Business Review, Federal Reserve Bank of Philadelphia, issue Jul, pages 15-30.
    3. McCauley, Joseph L. & Gunaratne, Gemunu H., 2003. "An empirical model of volatility of returns and option pricing," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 329(1), pages 178-198.
    4. Gemunu H. Gunaratne & Joseph L. McCauley, 2002. "A theory for Fluctuations in Stock Prices and Valuation of their Options," Papers cond-mat/0209475, arXiv.org.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Wayne, James J., 2014. "Generalized Second Law of Thermodynamics and Its Applications in Social Science," MPRA Paper 59734, University Library of Munich, Germany.
    2. Wayne, James J., 2013. "Fundamental Equation of Economics," MPRA Paper 59574, University Library of Munich, Germany.
    3. Josip Stepanic, 2004. "Social Equivalent of Free Energy," Interdisciplinary Description of Complex Systems - scientific journal, Croatian Interdisciplinary Society Provider Homepage: http://indecs.eu, vol. 2(1), pages 53-60.
    4. Zapart, Christopher A., 2015. "Econophysics: A challenge to econometricians," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 419(C), pages 318-327.
    5. Li, Shouwei & Zhuang, Yangyang & He, Jianmin, 2016. "Stock market stability: Diffusion entropy analysis," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 450(C), pages 462-465.
    6. Vítor A. F. Costa, 2024. "Looking at Economics through the Eyes of Thermodynamics," Energies, MDPI, vol. 17(11), pages 1-41, May.
    7. Pichl, Lukáš & Kaizoji, Taisei & Yamano, Takuya, 2007. "Stylized facts in internal rates of return on stock index and its derivative transactions," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 382(1), pages 219-227.
    8. Sousa, Tânia & Domingos, Tiago, 2006. "Equilibrium econophysics: A unified formalism for neoclassical economics and equilibrium thermodynamics," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 371(2), pages 492-512.
    9. Bucsa, G. & Jovanovic, F. & Schinckus, C., 2011. "A unified model for price return distributions used in econophysics," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 390(20), pages 3435-3443.
    10. Arthur Matsuo Yamashita Rios de Sousa & Hideki Takayasu & Misako Takayasu, 2017. "Detection of statistical asymmetries in non-stationary sign time series: Analysis of foreign exchange data," PLOS ONE, Public Library of Science, vol. 12(5), pages 1-18, May.
    11. Jovanovic, Franck & Schinckus, Christophe, 2017. "Econophysics and Financial Economics: An Emerging Dialogue," OUP Catalogue, Oxford University Press, number 9780190205034.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. McCauley, Joseph l., 2004. "Thermodynamic analogies in economics and finance: instability of markets," MPRA Paper 2159, University Library of Munich, Germany.
    2. McCauley, Joseph L., 2003. "Scaling, correlations, and cascades in finance and turbulence," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 329(1), pages 213-221.
    3. Bucsa, G. & Jovanovic, F. & Schinckus, C., 2011. "A unified model for price return distributions used in econophysics," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 390(20), pages 3435-3443.
    4. Shu-Heng Chen & Sai-Ping Li, 2011. "Econophysics: Bridges over a Turbulent Current," Papers 1107.5373, arXiv.org.
    5. Jovanovic, Franck & Schinckus, Christophe, 2017. "Econophysics and Financial Economics: An Emerging Dialogue," OUP Catalogue, Oxford University Press, number 9780190205034.
    6. Ramos, Antônio M.T. & Carvalho, J.A. & Vasconcelos, G.L., 2016. "Exponential model for option prices: Application to the Brazilian market," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 445(C), pages 161-168.
    7. Giacomo Bormetti & Sofia Cazzaniga, 2011. "Multiplicative noise, fast convolution, and pricing," Papers 1107.1451, arXiv.org.
    8. de Mattos Neto, Paulo S.G. & Silva, David A. & Ferreira, Tiago A.E. & Cavalcanti, George D.C., 2011. "Market volatility modeling for short time window," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 390(20), pages 3444-3453.
    9. Seemann, Lars & Hua, Jia-Chen & McCauley, Joseph L. & Gunaratne, Gemunu H., 2012. "Ensemble vs. time averages in financial time series analysis," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 391(23), pages 6024-6032.
    10. Marcin Wk{a}torek & Stanis{l}aw Dro.zd.z & Jaros{l}aw Kwapie'n & Ludovico Minati & Pawe{l} O'swik{e}cimka & Marek Stanuszek, 2020. "Multiscale characteristics of the emerging global cryptocurrency market," Papers 2010.15403, arXiv.org, revised Mar 2021.
    11. Jinkyu Kim & Gunn Kim & Sungbae An & Young-Kyun Kwon & Sungroh Yoon, 2013. "Entropy-Based Analysis and Bioinformatics-Inspired Integration of Global Economic Information Transfer," PLOS ONE, Public Library of Science, vol. 8(1), pages 1-10, January.
    12. Decamps, Marc & De Schepper, Ann & Goovaerts, Marc, 2004. "Applications of δ-function perturbation to the pricing of derivative securities," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 342(3), pages 677-692.
    13. Sosa-Correa, William O. & Ramos, Antônio M.T. & Vasconcelos, Giovani L., 2018. "Investigation of non-Gaussian effects in the Brazilian option market," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 496(C), pages 525-539.
    14. Shi, Leilei, 2006. "Does security transaction volume–price behavior resemble a probability wave?," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 366(C), pages 419-436.
    15. Giacomo Bormetti & Sofia Cazzaniga, 2014. "Multiplicative noise, fast convolution and pricing," Quantitative Finance, Taylor & Francis Journals, vol. 14(3), pages 481-494, March.
    16. Zheng, Zhiyong & Lu, Yunfan & Zhang, Junhuan, 2022. "Multiscale complexity fluctuation behaviours of stochastic interacting cryptocurrency price model," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 593(C).
    17. Victor M. Yakovenko & J. Barkley Rosser, 2009. "Colloquium: Statistical mechanics of money, wealth, and income," Papers 0905.1518, arXiv.org, revised Dec 2009.
    18. Haydar Akyazi & Seyfettin Artan, 2006. "Reflections of the New Economy on the Monetary Policy and Central Banking," Papers of the Annual IUE-SUNY Cortland Conference in Economics, in: Oguz Esen & Ayla Ogus (ed.), Proceedings of the Conference on Human and Economic Resources, pages 373-387, Izmir University of Economics.
    19. Leonard I. Nakamura, 2001. "Education and training in an era of creative destruction," Working Papers 00-13, Federal Reserve Bank of Philadelphia.
    20. Elena P. Antonacopoulou & Andri Georgiadou, 2021. "Leading through social distancing: The future of work, corporations and leadership from home," Gender, Work and Organization, Wiley Blackwell, vol. 28(2), pages 749-767, March.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:phsmap:v:329:y:2003:i:1:p:199-212. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.journals.elsevier.com/physica-a-statistical-mechpplications/ .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.