Entropy Dynamics in Financial Systems: A Thermofluid Framework for Risk, Uncertainty, and Market Inefficiency

Abstract

This investigation presents a brand-new thermodynamic approach to financial system analysis based on entropy generation concepts from fluid mechanics and heat transfer theory. The concept of financial entropy is utilized to quantify uncertainty in financial markets, and a governing equation is derived to govern financial entropy evolution in terms of both time and space, taking into account factors such as volatility, friction, and asymmetric information. Dimensionless variables are incorporated into the governing equation to generalize financial entropy evolution in different financial environments. Numerical calculations demonstrate that increasing factors such as volatility, transaction costs, and asymmetric information cause a substantial increase in financial entropy, indicating a more unstable financial environment. On the other hand, increased information diffusion in financial markets is shown to enhance financial stability. A financial Reynolds number is introduced to determine when financial markets become unstable and crisis-prone. It is shown that financial entropy-based modeling can provide a unified approach to understanding financial instability and can be useful in designing financial regulations. The results of the study reveal that the presence of diffusion enhances the entropy transport across market depth, whereas volatility increases disorder by incorporating fluctuations in the system.