Modelization and Calibration of the Power-Law Distribution in Stock Market by Maximization of Varma Entropy

Abstract

Proper description of the return distribution is crucial for investment practitioners. The underestimation of the tail risk may lead to severe consequences, even for assets with moderate fluctuations. However, many empirical studies found that the distribution tails of many financial assets drop off more slowly than the Gaussian distributions. Therefore, we intend to model and calibrate the heavy tails observed in financial fluctuations in this study. By maximizing the Varma entropy with value-at-risk and expected shortfall constraints, we obtain the probability distribution of stock return and observe that the tail of stock return distribution is a power law. Since the variance of the real stock portfolio may be a random variable, using the mean-VaR-ES constraints to maximize the Varma entropy effectively avoids the problem of assuming that the variance is a constant value under the traditional mean-variance constraint. Therefore, the deduced theoretical model would be more consistent with the real market. Using high-frequency data from China’s stock markets, we calibrate our theoretical model and give the concrete form of probability density distribution p(x) for different time intervals. The calibration results show that the tail of the stock return distribution is a power law with most of the power-law orders between −2 and −7. We prove the robustness of our results by calibrating the Varma entropy for S&P 500 of the USA stock market and different stock market indices in China’s A-share market. Our research’s findings not only offer a theoretical perspective for researchers but also give investing professionals a theoretical foundation on which to base their decisions.