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The Maximum-Entropy Distribution of the Future Market Price of a Stock

John M. Cozzolino and Michael J. Zahner
Operations Research
Vol. 21, No. 6 (Nov. - Dec., 1973), pp. 1200-1211
Published by: INFORMS
Stable URL: http://www.jstor.org/stable/168947
Page Count: 12
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The Maximum-Entropy Distribution of the Future Market Price of a Stock
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Abstract

This paper uses the principle of maximum entropy to construct a probability distribution of future stock price for a hypothetical investor having specified expectations. The result obtained is in good agreement with observations recorded in the literature. Thus, the paper concludes that the hypothetical individual investor is representative of a large class of investors. This new derivation of the well known random-walk theory of stock-price movements leads to an improved understanding of the model parameters by relating the variance of the random-walk process to the risk aversion of the investors. A practical use of the model is proposed to help the investor form an objective opinion of his skill.

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