Can chaotic dynamics predict stock returns
Question
Explain what chaos theory is. Could it be used to forecast stock returns?
Short answer
Chaos theory studies deterministic nonlinear systems whose behaviour looks random because tiny changes in initial conditions grow exponentially; in practice it has not delivered useful return forecasts. Even a truly chaotic market would be predictable only over very short horizons, since measurement error blows up fast. Empirical tests find little evidence of low-dimensional chaos in returns once noise and changing volatility are accounted for, and any exploitable structure would tend to be arbitraged away.
Adapted from Crack, Heard on the Street, Q3.5, p.33; question and answer rewritten by SelfMadeQuant.com.
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Open the worked solutionLessons behind this question
- Sample Spaces, Events, and the Probability Axioms
- Conditional Probability, Total Probability, and Bayes' Rule
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