Flash Crashes, Information Processing Limits, and Phase Transitions

Abstract

While a wide variety of causes have been offered to explain the anomalous market phenomena known as a “Flash Crash,” there is as of yet no consensus among financial experts as to the sources of these sudden market collapses. In contrast to the behavior expected from standard financial theory, both the equity and bond markets have been thrown into freefall in the absence of any significant news event. The author posits that information theory offers a relatively simple explanation of the causes of some of these dramatic events. This new avenue of research also suggests new policies or measures to lower the probability of occurrence and to mitigate the effects of these extreme events.

Keywords: Information Theory, financial engineering, yield curve, econophysics, entropy, implied volatility

JEL Classification: G1, G12, G14, G170, D84, E43