ANALYSIS OF FAT TAIL DISTRIBUTION,

LONG TAIL DISTRIBUTION

 NORMAL DISTRIBUTION

• Lengths, Weight, IQ, Grade

• Value up to 3 standard deviation
 FAT TAIL DISTRIBUTION

• Higher than expected

probability of occurrence of
extreme events
• For example:
-Catastrophic events like
earthquake
-Dot com bubble ( 1994 to 2000)
 CONSEQUENCES OF FAT TAILS

• Extreme events occurs more than expected

• Law of large numbers work slowly (central limit theorem)

• Mean of distribution will not correspond to sample mean

• True degree of financial difficulty is understated

• White Swan and Black Swan events

• White swan: everyone knows whwn something unexpected will happen but they don’t
know whe it will happen
• Black swan: unknown unknown
 APPLICATIONS IN ECONOMICS

• Fat tails are considered undesirable in finance because of additional risk.

• Normal distribution assumes the factors influencing an asset's value or

price are mathematically "well-behaved”.

• But real world events are not usually mathematically well-behaved.

• Investor excessive optimism or pessimism leading to large market moves

• For instance: Financial Crisis 2008/2009

 SERIOUS FAT TAILS

• Pareto law

• The ratio of people with $ 16 million compared to $ 8 million is the

same as the ratio of people with $ 2 million and $ 1 million.
• No mean and standard deviation
CAUCHY DISTRIBUTION

• Cauchy distribution is an example of Fat Tail distribution.

• Benoit Mandebrot,, The Misbehaviors of the Market ,

• Fractals

• market bubbles and busts are due to the fact that most financial analysis assumes a Normal distribution
in their models, while the Cauchy distribution much better describes real world market behavior.
BLIND ARCHER PROBLEM (EXAMPLE
OF CAUCHY DISTRIBUTION)
• Blind ARCHER IS STANDING IN FRONT OF TARGET AND CAN HIT ANYWHERE IN
• SEMICIRCLE IN FRONT OF HIM (-pi/2 to +pi/2)

Pdf:

Cdf:
FAT TAIL AND FINANCIAL CRISIS

• Fat tail is a probability distribution

• Predicts the movements of three or more Standard deviation more
frequently than a normal distribution
• Normal distribution understates assets prices, stock returns and
subsequent risk management strategies
 FINANCIAL CRISIS 2008

Subprime Larger
Credit default
loans leverage
swaps
ratio
 CONSEQUENCES

• Major Companies went under (Bear Sterns, Lehman Brothers)

• Market Crashed

• Foundation of global economic system was undermined.

• 99.7% variance fall within three SD of its mean, the notion of
visible profits and invisible losses created a high risky financial
environment.
• Models must focus on how the behavior of assets relates and
contributes to fat tails in order to adequately manage tail risk.
 TAIL RISK HEDGING

• Appropriate strategy after a market crisis

• Aims to enhance long term return

• Liability hedging and diversification

 DIVERSIFICATION
• Holding uncorrelated assets

• Includes derivatives and short volatility index

For instance, An investor who has a stock in S&P 500 index can
hedge against tail risk by purchasing derivatives from Chicago Board
Option Exchange volatility index which is inversely correlated to
S&P 500
 LIABILITY HEDGING
• Reduce exposure to change in interest rate, inflation and equity
volatility
• Short term cost

• Mitigate loss and provide liquidity during crisis

• Don’t take much debt

• Risk is probable but ruin is real.

 CONCLUSION

• Fat tail indicate there is probability that an investment move beyond

three standard deviations.

• Fat tail are often seen when looking at hedge fund.

• Causes of financial crisis of 2008 are:

– Subprime loan
– Credit default swap
– Large leverage ratio
• Left fat have devastating effects on portfolio returns.

• Tail risk hedging is an alternative model for managing risk in

investment portfolio.
 REFERENCES
https://en.wikipedia.org/wiki/Fat-tailed_distribution

https://www.academia.edu/37221402/STATISTICAL_CONSEQUENCES_OF_FAT_TAILS_TEC
HNICAL_INCERTO_COLLECTION
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