Econophysical models of finance: Baryonic beta dynamics and beyond

Econophysics applies the techniques of physics and nonlinear dynamics to complex economic problems. This article invokes econophysics in order to introduce a theoretical model that aspires to encompass all essential features of real financial markets. It summarizes the central argument of my book, Econophysics and Capital Asset Pricing: Splitting the Atom of Systematic Risk (Palgrave Macmillan 2017). By analogy to quantum chromodynamics and other aspects of the Standard Model of particle physics, that book, and this article, seek to rehabilitate the capital asset pricing model splitting beta, the basic unit of systematic risk, into subatomic (or “baryonic”) components.

This article then transcends the limitations of Econophysics and Capital Asset Pricing by offering preliminary thoughts on the application of physics to other dimensions of finance. Although Econophysics and Capital Asset Pricing addressed the diffusion of financial information and intertemporal asset pricing, it did not incorporate those subjects into a consciously physical framework. This article proposes to integrate the baryonic model of beta — which is essentially a spatial representation of comovement between individual firms, capital markets, and the real economy — with the informational and temporal dimensions of finance.

Behaviorally mediated departures from pure rationality remind us that financial reasoning combines psychological perception with physical mechanics. The conical or cylindrical representation of color as the function of hue, saturation, and value (HSV) therefore provides an apt psychophysical model of finance. These three dimensions of color correspond to three distinct aspects of finance:

1. Value, in the sense of pure darkness or brightness, expresses the extent to which information has permeated financial markets.
2. Saturation quantifies the richness of color relative to the gray axis at the center of HSV colorspace. Its economic equivalent consists of different levels of comovement, from correlation between individual securities, asset classes, and capital markets, to interactions between firm-specific cash-flow effects and macroeconomic discount-rate effects.
3. The idea of hue describes economic fluctuations within a circular representation of the real economy. Even if boom-and-bust "cycles" are not predictability periodic, the temporal aspects of finance can be described — graphically as well as verbally — in angular terms.

Mindful that economics serves human goals, this article concludes by finding anthropocentric anchors within the otherwise neutral framework of the physics of the very small (the standard model) and of the very large (astrophysics).