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Fat-tailed distribution

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

The distribution of a random variable X is said to have a fat tail if

That is, if X has probability density function ,

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).

Fat tails and risk estimate distortions

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]

The BlackScholes model of option pricing is based on a normal distribution. If the


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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