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Quantify Fat Tails Skewness: Figure 3: Skewness of A Standard Normal Distribution, Splus

The document discusses quantifying fat tails and skewness in distributions. It provides definitions for skewness and kurtosis of a distribution. The skewness of a standard normal distribution is 0. Examples are given of crash models with different jump probabilities and sizes that result in different levels of skewness. The document proposes a utility function that captures an investor's preference for skewness in addition to return and risk. It modifies an original optimization problem to account for both an investor's skewness preference and the negatively skewed returns of the risky asset.

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8 views6 pages

Quantify Fat Tails Skewness: Figure 3: Skewness of A Standard Normal Distribution, Splus

The document discusses quantifying fat tails and skewness in distributions. It provides definitions for skewness and kurtosis of a distribution. The skewness of a standard normal distribution is 0. Examples are given of crash models with different jump probabilities and sizes that result in different levels of skewness. The document proposes a utility function that captures an investor's preference for skewness in addition to return and risk. It modifies an original optimization problem to account for both an investor's skewness preference and the negatively skewed returns of the risky asset.

Uploaded by

engineeringboy007
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Quantify Fat Tails Skewness

Skewness
E (x − E (x))3
skew (x) = (1)
std (x)3

Kurtosis
E (x − E (x))4
kurto (x) = (2)
std (x)4

What is the skewness of a standard normal?


0.5
0.4
0.3
0.2
Skewness / Normal

0.1
0.0
-0.1
-0.3
-0.5

-5 -4 -3 -2 -1 0 1 2 3 4 5

Figure 3: Skewness of a standard normal distribution, splus.

What is the kurtosis of standard normal?


Caution: skewness and kurtosis might not exist for some random variables.
A Model with Event Risk

Daily Return r:

r =x+y

x is the ”normal” component:

y is the ”jump” component:


�
J with probability p
y=
0 with probability 1-p

x and y and are independent.


Moments of the Crash Model

mean
E (r) = µ + J · p (3)

variance:
var (r) = σ 2 + J 2 · p · (1 − p) (4)

skewness:
J 3 · p · (1 − p) · (1 − 2p)
skew (r) = � (5)
3
var (r2 )
The Skewness of the Crash Model

Model P J skew

once a month 1/12 -2% -1.0

once a year 1/365 -10% -5.6

once a lifetime 1/365/100 -50% -7.1

Each jump model is calibrated so that the annualized expected return is 12%, and the
annualized volatility is 15%.

That is, the returns from the three models are equally attractive to a mean-variance
investor!
Skewness Preference

A utility function that captures the risk attitude of an investor in three ways:

1 1
U (r) = E (r) − · A · var (r) + · B · E (r − E (r))3 (6)
2 6

1. the expected return is desirable;

2. the variance of return is undesirable (A > 0);

3. positive skewness is desirable, negative skewness is not (B > 0).

If we set B = 0, we are back to a mean-variance investor.


Modifying the Original Problem

Two modifications of our original problem:

1. Investor has a preference for skewness;


1 1
U (r) = E (r) − · A · var (r) + · B · E (r − E (r))3 (7)
2 6

2. The risky asset rP is negatively skewed:

skew = -2

The optimization problem:

max
U (ry ) (8)
y∈R

Just as before, rP is the portfolio return:

ry = (1 − y) · rf + y · rp (9)

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