The Fractal Market Hypothesis

J M Blackledge

Stokes Professor of DSP (ICT)

Dublin Institute of Technology
http://eleceng.dit.ie/blackledge
 What is Capitalism ?

Greed Fear
Balance
 The Price of Greed

Greed Fear
Balance
 Contents of Presentation
• What are Fractals?

• Random Fractal Walkers

• The Origins of Mathematical Finance

• The Fractal Market Hypothesis (FMH)

• Some Example Results?

• Questions
 Fractal:
Where does the word come from?
“The term fractal is derived from the Latin adjective
fractus. The corresponding Latin verb frangere
means ‘to break’, to create irregular fragments.
In addition to ‘fragmaneted’ fractus should also
mean ‘irregular’, both meanings being preserved
in fragment”.
B Mandelbrot
 What are Fractals?

Euclidean objects Fractal objects

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 Example: The Sierpinski Triangle

• N=3, r=1/2 at each step

NrD = 1 • D=log(3)/log(2) =1.584962501...
Euclidean & Fractal Dimensions

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Self-Similarity:
 Underlying Philosophy
In every way one can see the shape of the sea

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The Fractal Geometry of Nature
 Fractals and Texture

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“Much of Fractal Geometry can be considered

to be an intrinsic study of texture” B Mandelbrot
Fractal Clouds: D=2.1
Fractal Clouds: D=2.2
Fractal Clouds: D=2.3
Fractal Clouds: D=2.4
Fractal Clouds: D=2.5
Fractal Clouds: D=2.6
Fractal Clouds: D=2.7
Fractal Clouds: D=2.8
Fractal Clouds: D=2.9
 Fractal Art:
The CAD of Natural Objects

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 Random Fractal Walkers

Brownian
Motion
 Random Fractal Walks with a
Variable Hurst Exponent
H=0.6 H=0.7

H=0.8 H=0.9
 Random Fractal Walks and
Partial Differential Equations

Hurst exponent H: Fourier dimension:

0<H<1 0<q<2; D=(5-2q)/2, 0.5<q<1.5
• q=1: Diffusion Equation
• q=2: Wave Equation
• 1<q<2: Fractional (Fractal) Diffusion Equation
H>0.5 (q>1): random walk with persistence
and directional bias
 Example: Diffusion of Light

Source imaged Source imaged Source convolved

through air through steam with a Gaussian PSF
 Fractional Calculus

• L’hospital to Leibnitz (1695):

‘Given that dnf/dtn exists for all integer n,
what if n be 1/2'.

• Leibnitz to L’hospital:
‘It will lead to a paradox ... From this
paradox, one day useful consequences
will be drawn'.
Fractional Integration
Origins of Mathematical Finance
The Theory of
Speculation
Louis Bachelier, PhD
Thesis, 1900
• Used Brownian motion to
evaluate stock options.
• Basis for the EMF
Efficient Market Hypothesis
 EMH .v. FMH:
Principal Differences
 Example of EMH:
Black-Scholes Analysis

Assumes market is a
stationary Gaussian
process!
 Is an economy based on
Stationary Gaussian Processes?
FTSE: 1984-2007

Log price difference

White Gaussian noise

Does an economy have memory?
Absolute Log price difference

Autocorrelation function
 Does an economy have
repeating patterns? (Elliot Waves)
0 .9 5

0 .9
2004-08 (April)
0 .8 5
1994-98 (April)
0 .8
1984-88 (April)
0 .7 5

0 .7

0 .6 5

0 .6

0 .5 5

0 .5
Normalised FTSE (COD) Macrotrends
0 .4 5
0 200 400 600 800 1000 1200
 Is an economy a
random fractal walk?
2700

2600

2500

2400

2300

2200

2100

2000

1900

1800

1700
0 2 00 400 600 800 1 00 0 1200

Hilbert
Transform
 Unification of the Observations:
The FMH with Black Swans

The FMH operator

q(t)=1.8
q(t)=1.1
q(t)=1.1
q(t)
 Does the FMH work?
FMH Simulation

Dow Jones Reality

EMH
 Non-stationary Signal Processing

• Requires application of ‘moving windows’ to

compute q(t) at different scales:
Time-frequency methods in DSP

• Hypothesis:
A change in q(t) precedes a change in a
macroeconomic index (e.g. FTSE)
 Equivalence with
Wavelet Analysis

• Wavelet Transform

• FMH Transform
 Example: FTSE (COD)
19 March 2004 – 26 November 2008
q(t)

FTSE (Normalised)

Min on 10 May ‘07

Macrotrends
Max on 19 June ‘07

Normalised
Gradients
 Does it work over
smaller times scales?
q(t)
FTSE (Normalised): Jan-May, 2007

Macrotrends

Gradients
 Systems Development
Fuzzy logic Decision
q[i]
DSP
Feature
vector
Economic signal
Knowledge
Data Base
q[i+1]-q[i]<0: good market
q[i+1]-q[i]>0: poor market
Feature vector includes:
• Information Dimension - ‘Fractal Entropy’
• Correlation Dimension - ‘Fractal Matched Filter’
• Multi-fractals - c.f. Statistical Moments

Example system: http://www.tradingsolutions.com

 The Fractal Market Hypothesis
• Market dynamics are fractional dynamics

• Economic signals are random fractals with non-

stationary characteristics

• FMH operator:

• Methods of solution given in

Application of the Fractal Market Hypothesis for Modelling
Macroeconomic Time Series
Blackledge J M, ISAST Transactions on Electronics and
Signal Processing, No.1 Vol. 2, 89-110, 2008 (ISSN:1797-
2329) http://www.isastorganization.org/ES2ready.pdf
Questions