The Origin of Fat Tails
AbstractWe propose a random walk model of asset returns where the parameters depend on market stress. Stress is measured by, e.g., the value of an implied volatility index. We show that model parameters including standard deviations and correlations can be estimated robustly and that all distributions are approximately normal. Fat tails in observed distributions occur because time series sample different stress levels and therefore different normal distributions. This provides a quantitative description of the observed distribution including the fat tails. We discuss simple applications in risk management and portfolio construction
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Bibliographic InfoPaper provided by arXiv.org in its series Papers with number 1310.4538.
Date of creation: Oct 2013
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Web page: http://arxiv.org/
This paper has been announced in the following NEP Reports:
- NEP-ALL-2013-10-25 (All new papers)
- NEP-ECM-2013-10-25 (Econometrics)
- NEP-FMK-2013-10-25 (Financial Markets)
- NEP-RMG-2013-10-25 (Risk Management)
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- Lux, Thomas, 1998. "The socio-economic dynamics of speculative markets: interacting agents, chaos, and the fat tails of return distributions," Journal of Economic Behavior & Organization, Elsevier, vol. 33(2), pages 143-165, January.
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