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A fat-tailed distribution is a probability distribution that has the property, along with the

other heavy-tailed distributions, that it exhibits large skewness orkurtosis. This

comparison is often made relative to the ubiquitous normal distribution, or to

the exponential distribution. Fat-tailed distributions have been empirically encountered

in a variety of areas: economics, physics, and earth sciences. Some fat-tailed

distributions have power law decay in the tail of the distribution, but do not necessarily

follow a power law everywhere.

Definition

Here the tilde notation " " refers to the asymptotic equivalence of functions.

Some reserve the term "fat tail" for distributions where 0 < < 2 (i.e. only in

cases with infinite variance).

By contrast to fat-tailed distributions, in the normal distribution events that deviate from

the mean by five or morestandard deviations ("5-sigma events") are extremely rare, with

10- or more sigma events being practically impossible. On the other hand, fat-tailed

distributions such as the Cauchy distribution (and all other stable distributions with the

exception of the normal distribution) are examples of fat-tailed distributions that have

"infinite sigma" (more technically, the variance does not exist).

Thus when data naturally arise from a fat-tailed distribution, shoehorning the normal

distribution model of riskand an estimate of the corresponding sigma based

necessarily on a finite sample sizewould severely understate the true degree of

predictive difficulty. Manynotably Benot Mandelbrot as well as Nassim Talebhave

noted this shortcoming of the normal distribution model and have proposed that fat-

tailed distributions such as the stable distributions govern asset returns frequently found

in finance.[2]

distribution is actually a fat-tailed one, then the model will under-price options that are

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far out of the money, since a 5- or 7-sigma event is much more likely than the normal

distribution would predict.

Applications in economics

In finance, fat tails are considered undesirable because of the additional risk they imply.

For example, an investment strategy may have an expected return, after one year, that

is five times its standard deviation. Assuming a normal distribution, the likelihood of its

failure (negative return) is less than one in a million; in practice, it may be higher.

Normal distributions that emerge in finance generally do so because the factors

influencing an asset's value or price are mathematically "well-behaved", and the central

limit theorem provides for such a distribution. However, traumatic "real-world" events

(such as an oil shock, a large corporate bankruptcy, or an abrupt change in a political

situation) are usually not mathematically well-behaved.

Historical examples include the Black Monday (1987), Dot-com bubble, Late-2000s

financial crisis, and the unpegging of some currencies.[3]

Fat tails in market return distributions also have some behavioral origins (investor

excessive optimism or pessimism leading to large market moves) and are therefore

studied in behavioral finance.

In marketing, the familiar 80-20 rule frequently found (e.g. "20% of customers account

for 80% of the revenue") is a manifestation of a fat tail distribution underlying the data.

The "fat tails" are also observed in commodity markets or in the record industry. The

probability density function for logarithm of weekly record sales changes is highly

leptokurtic and characterized by a narrower and larger maximum, and by a fatter tail

than in the Gaussian case. On the other hand, this distribution has only one fat tail

associated with an increase in sales due to promotion of the new records that enter the

charts.

Applications in geopolitics

In The Fat Tail: The Power of Political Knowledge for Strategic Investing, political

scientists Ian Bremmer and Preston Keat propose to apply the fat tail concept to

geopolitics. As William Safire notes in his etymology of the term, [5] a fat tail occurs when

there is an unexpectedly thick end or tail toward the edges of a distribution curve,

indicating an irregularly high likelihood of catastrophic events. This represents the risks

of a particular event occurring that are so unlikely to happen and difficult to predict that

many choose to ignore their possibility. One example that Bremmer and Keat highlight

in The Fat Tail is the August 1998 Russian devaluation and debt default. Leading up to

this event, economic analysts predicted that Russia would not default because the

country had both the ability and willingness to continue to make its payments. However,

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political analysts argued that Russias fragmented leadership and lack of market

regulationalong with the fact that several powerful Russian officials would benefit from

a defaultreduced Russias willingness to pay. Since these political factors were

missing from the economic models, the economists did not assign the correct probability

to a Russian default.

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