Didier Darcet
1 August 2019

Theory of Financial Fragility-Conceptual Framework

The Theory of Financial Fragility anticipates the behaviour of financial assets in times of stress. Such anticipation not only requires a new conceptual framework regarding market arbitration, but also the help of modern physics and its understanding of energy transfers. “Introduction to Financial Entropy” and “The Energy of a Fragile Asset”, published earlier this year, dealt with the financial interpretation of various forms of energy, such as potential energy associated with expected returns, kinetic energy associated with asset variance and “uncontrollable”, “risky”, or “useless” energy associated with entropy. The Theory of Financial Fragility considers assets as species in an ecological competition vying to access the “useful” part of energy, also known as “free energy”. In other words, finance is no exception. It is governed by physical laws, and by an arbitration principle among strategies competing for survival. Understanding survival strategies is key to identifying potential winners and losers in periods of stress, and to build investment portfolios with heightened robustness. This letter focuses on the conceptual framework: the specifics of self-organized structures that ‘dissipate’ energy, such as planet Earth, living organisms, economic systems, financial markets, and many other systems that shape the evolution of mankind and, to a larger extent, the evolution of the universe, in their own way.