Empirical implementation of entropy risk factor model: A test on Chilean peso

Abstract

Currencies are used by many investors as a speculative or investment instrument. Their movements are complex and there are exchange rate models which suggest how to predict long and short-term fluctuations. In this paper we investigate the predictability of an exchange rate with an entropy risk factor model. Considering that recent studies find complex systems characteristics of financial markets, we explore the usefulness of sample entropy as a risk factor for currency fluctuations. The empirical testing of sample entropy is based on the data of the Chilean peso (CLP) exchange rate for the period of January 1, 2005 and November 25, 2016. We find evidence that Chilean peso market has enough market inefficiencies that can be profitably exploited by the sample entropy based prediction algorithm developed in this paper.