Appl. Math. Lat. Vol. 2, No. 3. pp. 301-304. 1989 0893-9659!89 53.00 + 0.

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Stable Distributions for Asset Returns

~STEFAN WTTNIK, ?SVETLOZAR T. RACHEV

‘Department of Economics
State University of New York at Stony Brook;

*Statistics and Applied Probability Program,

University of California

Abstract. Alternativestabledistributionsfor modeling returns on f?nancial assets are proposed.

Their goodness-of-fit with respect to daily stock-index data is compared.

1. INTRODUCTION

Since the work of Mandelbrot [l], the statistical distribution of returns on financial as-
sets such as stocks, foreign currencies, precious metals, etc. is widely studied. Empirical
distributions of asset returns are generally leptokurtic and thus violate the normality as-
sumption. Mandelbrot, and later Fama [?I, proposed the stable Paretian distribution,
which includes the normal distribution as a special case, as an alternative for modeling
asset returns. An attractive feature of the stable Paretian distribution is its stability, i.e.,
closure under summation, implying that the shape parameter, characteristic exponent o,
is invariant with respect to the length of the sampling interval. In the context of stock re-
turns, several empirical studies (see, for example, Akgiray and Booth [3]), however, find
that Q increases when the sampling interval is lengthened, violating the stability assump-
tion. Since stability and stab/e Paretian are generally viewed synonymously in the econom-
ics and finance literature, the stability of asset-return distributions is now widely rejected.
The purpose of this paper is to report on results obtained with alternative distrib
utions that are stable but not of the stable Paretian type. These alternative distributions
are the limit distributions of particular probabilistic schemes with respect to which they
are stable. The results will be reported in detail in [4]. In [5] we explicitly discuss the
Weibull distribution, which, among the cases considered, turns out to be the most appro-
priate stable distribution for the modeling stock returns.

2. ALTERNATIVE STABLE DISTRIBUTIONS

Let X1,X,,... be independently and identically distributed real-valued random varia-

bles (r.v.‘s). In our context, Xi denotes the return on an asset in period i. To categorize
the probabilistic schemes considered, we write

d
x, = aN(X10X20. . .oX,J + b,

where 4 denotes equality in distribution; o stands for summation, min, max, or multi-
plication; and N is a deterministic or stochastic integer. The probabilistic schemes and

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302 S. MITTNIK, S.T. RXCHEV

the resulting limit distributions are summarized in Table 1; for details see (41.
In the deterministic case, N=n represents a deterministic integer. The standard sum-
mation scheme produces the stable Paretian distribution. The maximum and minimum
schemes lead to extreme-value distributions. For the minimum scheme, the Weibull dis-
tribution is one of these extreme-value distributions. The multiplication scheme yields
the multiplication-stable distribution of which the log-normal is the basic example.
In the stochastic case, we set N=S(p), where S(p) is specified as a geometrically dis-
tributed r.v. with parameter p~(O,l) independent of Xi. The Weibull distribution arises
as the limit distribution of the geometric summation scheme. The geometric maximum,
minimum and multiplication schemes produce (geometric,max)-, (geometric,min)-, and
(geometric,multiplication)-stable distributions, respectively.

Table 1. Overview of Probabilistic Schemes

Probabilistic Scheme Stability Property Stable Distribution

Summation an(Xr+. . .+X,,)+b$X1 stable Paretian

Maximum an 1rnF2nXi+bngX, max-stable

_-
Minimum anlyiii<nnXi+bngX1 min-stable
__
end
Multiplication An(X,**.Xn) =X1 multiplication-stable

Geometric Summatiora(p)(X,+. . .+X,f,))+b(p)gX, (geometric,sum)-stable

Geometric Maximum a(p) max Xi+b(p)~X1 (geometric,max)-stable

l&S(o)
Geometric Minimum a(p) l<i<s(pJ
min Xi+b(P)‘X1 (geometric,min)-stable
__
UPI
Geometric Multipl. A(p)(X,*..Xs(p,) gXl (geometric,mult.)-stable

3. EMPIRICAL COMPARISON

To examine the goodness-of-fit of the alternative stable distributions, we fitted them

to daily Standard and Poor’s 500 (S&P 500) index data (measured in first differences of
the natural logarithm of the level of the index). The Kolmogorov distance, p=]Fs(x)-
F(x)/ (multiplied by loo), and its normalization T1’2 p is used to measure the goodness-
of-f-it. Here, F,(x) denotes the sample distribution, f(x) is the estimated distribution
function, and T is the sample size. Table 2 reports the fit of the distributions for 1, 2, 3,
4, and 5 year samples. (All samples end on December 31, 1986.) In some cases, the dis-
tributions are not defined for the whole real line. In this case we fitted the positive and
the absolute values of the negative returns separately.
The results show that among the distributions considered, the Weibull distribution,
generated by the min-stable as well as the geometric summation scheme, provides the
best model. In all 5 sample periods the Weibull dist,ribution fits substantially better than
 Stable Distributions for Asset Returns 303

any of the other models, including the stable Paretian distribution. When comparing
Weibull and stable Paretian distributions over sample periods of up to 30 years, the
Weibull distribution fits consistently better (see [4]). In addition to its superior tit, we
find that for the Weibull distribution the normalized Kolmogorov distances remain f irly
constant as T varies. Provided that the correct distribution is fitted, we expect pT1 B2 to
be roughly constant and not to depend on the sample size T.

Table 2. Comparison of Fit

Sample (years)a
Distribution
1 2 3 4 5

stable Paretian 5.00 6.68 8.32 6.09 7.47

0.80 1.50 2.29 1.94 2.66

max-stable 5.73 5.17 5.27 4.86 4.71

0.91 1.16 1.45 1.55 1.67

min-stable 2.27 2.32 1.62 1.07 1.07

(Weibull) 0.36 0.52 0.45 0.34 0.38

mult.-stable 3.66 3.16 4.52 4.45 4.28

(Log-normal) 0.58 0.71 1.25 1.42 1.52

(geo,sum.)-stable See min-stable distribution.

(Weibull)

(Laplace) 8.27 8.02 7.44 7.61 7.48

1.34 1.80 2.05 2.42 2.66

(geo,max)-stable 3.91 3.38 2.88 2.85 3.07

0.62 0.76 0.79 0.91 1.09

(geo,min)-stable See (geo,max)-stable distribution.

(geo,mult.)-stable 8.27 7.59 7.91 7.60 8.30

1.32 1.71 2.18 2.42 2.95

a The entries in the first row of each case represent the

Kolmogorov distance p=suplF,(x)-F(x)1 multiplied by 100.
The entries in the second row are given by PT”~, where T
denotes the sample size.

AML 22-G
304 S. MITTNIK, S.T. RACHEV

4. DISCUSSION

As discussed in (51, in addition to its superior fit, the Weibull distribution possesses a
number of interesting properties, which we only mention here.
(i) While permitting fatter than normal tails, the Weibull distribution has expo-
nential tails. Consequently, and in contrast to the stable Paretian distribution, all
moments exist. This is an attractive implication of our findings, since the existence of
variances is crucial for a variety of economic/financial theories as well as econometric
techniques.
(ii) In contrast to the stable Paretian distribution, estimating the parameters of the
Weibull distribution via maximum likelihood methods or regression-type estimators is
straightforward. Also, given the existence of closed-form expressions, the construction of
estimated Weibull distribution functions presents no problem.
(iii) When fitting daily and monthly data over the same sampling periods, the
Weibull distribution exhibits invariance of the shape parameter with respect to the
sampling interval (the shape parameters remain within one-standard-deviation interval),
while the stable Paretian distribution violated this stability property.
(iv) Simulation results indicate that, when fitting the stable Paretian distribution to
data drawn from a Weibull distribution, the estimated characteristic exponents of the
stable Paretian distriution increase when the sampling interval is lengthened. The
increases are similar to the ones observed empirically when fitting asset-return data.
(v) In reliability theory the Weibull distribution with shape parameter a is known to
be a distribution with increasing failure rate if a>1 and a distribution with decreasing
failure rate if ~21. In the context of modeling asset returns, one could characterize a
Weibull distribution as a distribution with stabilizing tendency when cr 2 1 and as a distri-
bution with destabilizing tendency when (~51. Fitting the Weibull distribution to various
samples of the S&P 500 data, we find that, except in one case, all estimated shape
parameters are greater than unity. The exception is the sample covering 1986, where the
shape parameter for the absolute values of the negative returns is 0.919, indicating that
increasing negative stock price movements are likely. \Vhether this may be interpreted as
an omen for the stock market crash in the following year remains to be investigated.

REFERENCES

1. B.B. Mandelbrot, The Variation of Certain Speculative Prices, J. Bus. 2G (1963), 39-I-419.
2. E. Fama, The Behavior of Stock Market Prices, J. Bus 38 (1965), 34-105.
3. V. Akgiray, G.G. Booth, The Stable-Law Model of Stock Returns, J. Bus. Econ. Statist. G (1988),
51-57.
4. S. Mittnik, S.T. Rachev, Modeling Speculative Prices with Alternative Stable Distributions, in prepa-
ration.
5. S. Mittnik, S.T. FLachev, A Stable Random Summation Model with Finite Variance for Speculative
Prices, unpublished manuscript.

Dept. of Economics, State University of New York at Stony Brook

Stony Brook, N.Y. 11794-4384
Statistics and Applied Probability Program, University of California,
Santa Barbara, CA 93106