Financial Information Theory

TL;DR

This paper develops a comprehensive information-theoretic framework for financial time series analysis, introducing new measures and algorithms for regime detection, market efficiency testing, and risk management, validated on 25 years of S&P 500 data.

Contribution

It systematically derives and proves properties of information-theoretic measures applied to finance, and proposes practical algorithms for empirical analysis and decision-making.

Findings

Normalized mutual information effectively detects structural market changes.

Information-theoretic measures outperform traditional methods in regime detection.

New risk management tools based on entropy and mutual information are proposed.

Abstract

This paper introduces a comprehensive framework for Financial Information Theory by applying information-theoretic concepts such as entropy, Kullback-Leibler divergence, mutual information, normalized mutual information, and transfer entropy to financial time series. We systematically derive these measures with complete mathematical proofs, establish their theoretical properties, and propose practical algorithms for estimation. Using S&P 500 data from 2000 to 2025, we demonstrate empirical usefulness for regime detection, market efficiency testing, and portfolio construction. We show that normalized mutual information (NMI) behaves as a powerful, bounded, and interpretable measure of temporal dependence, highlighting periods of structural change such as the 2008 financial crisis and the COVID-19 shock. Our entropy-adjusted Value at Risk, information-theoretic diversification criterion, and NMI-based market efficiency test provide actionable tools for risk management and asset allocation. We interpret NMI as a quantitative diagnostic of the Efficient Market Hypothesis and demonstrate that information-theoretic methods offer superior regime detection compared to traditional autocorrelation- or volatility-based approaches. All theoretical results include rigorous proofs, and empirical findings are validated across multiple market regimes spanning 25 years of daily returns.