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Assignment

On
Basic concept of Skewness, Kurtosis, and Fat
tail event


Course title: Financial Engineering
Course no: FNB-405


Submitted To:
Mr. Nafeez Al Tarik
Course Instructor




Submitted By:
Urmi Das
Id: 589
BBA Program
Batch - 02







Savar, Dhaka-1342
July 19, 2014

Department of Finance & Banking
Jahangirnagar University




Skewness:
Skewness is a measure of the asymmetry of probability distributions. Skewness can be mathematically
defined as the averaged cubed deviation from the mean divided by the standard deviation cubed. For
univariate data Y
1
, Y
2
... Y
N
, the formula for skewness is:
Skewness =


A nonsymmetrical or skewed distribution occurs when one side of the distribution does not mirror the other.
Applied to investment returns, the result found from this formula can derive three scenario, and based on
these scenarios the investors can take many financial decision.
Firstly, the result of the skewness can be derived zero. The zero skewness means data are symmetrical
and the skewness for a normal distribution is always zero
If skewness is positive, the data are positively skewed or skewed right, meaning that the right tail of the
distribution is longer than the left. Positive skew would mean frequent small negative outcomes which is
deriving frequent small losses and a few extreme gains. That means extremely bad scenarios are not as
likely to come in this situation


Figure 01: Negative and Positive skew
If skewness is negative, the data are negatively skewed or skewed left, meaning that the left tail is longer.
Negatively skewed distributions that is called a long left tail indicates that investors can mean a greater
chance of extremely negative outcomes. Thus the investor can predict frequent small gains and a few
extreme losses.

Kurtosis:
Kurtosis is a statistical measure of the peak of a distribution, and indicates how high the distribution is
around the mean. More peak than normal means that a distribution has fatter tails and that there are lesser
chances of extreme outcomes compared to a normal distribution. The kurtosis can be measured by the
following equation for unvitiated data Y
1
, Y
2
... Y
N
:
Kurtosis=


Here Y is the mean, s is the standard deviation, and N is the number of data points. For this equation the
reference standard is a normal distribution, which has a kurtosis of 3. In token of this, often the excess
kurtosis is presented where the excess kurtosis is simply kurtosis3. Depending on this result the kurtosis can
take three forms. These are given bellow:
Here, Y is the mean, s is the standard deviation, and N is the number of data
points.
Mesokurtic distribution: A normal distribution has kurtosis exactly 3 (excess kurtosis exactly 0) is
called mesokurtic. The most prominent example of a mesokurtic distribution is the normal
distribution family, regardless of the values of its parameters.

Leptokurtic distributions: A distribution with kurtosis <3, that means distribution with positive
excess kurtosis is called leptokurtic distributions. Compared to a normal distribution, its central peak
is lower and broader, and its tails are shorter and thinner. Examples of leptokurtic distributions
include the student's t-distribution, rayleigh distribution, laplace distribution, exponential
distribution, poisson distribution and the logistic distribution.

Platykurtic distributions: A distribution with kurtosis >3 and negative kurtosis excess kurtosis is
called platykurtic distributions. In terms of shape, a platykurtic distribution has a lower, wider peak
around the mean and thinner tails. Examples of platykurtic distributions include the continuous or
discrete uniform distributions, and the raised cosine distribution.

The three types of kurtosis i.e. mesokurtic distribution, leptokurtic, platykurtic distributions is shown in
the figure bellow:

Figure 02: Different kurtosis distribution

Market implementation of skewness and kurtosis:
The basic tenets underlying the risk management policies and techniques that are generally employed in
financial markets make perfect theoretical sense. This perfect market concept ensures a normal distribution
of all the financial information i.e. stock price, return, value but that have been ineffective in protecting
investors from the risks that they faced. For that reason investors have to be concerned about some other
issues in the portfolio selection which includes the measure of volatility that is generally used, i.e. standard
deviation. Standard deviation purports to provide us with a measure of how much a variable for our
purposes, the value of an investment will vary from its mean, or expected value. The problem is, however,
that standard deviation does not at all adequately describe the possible actual outcomes of financial markets.
There are, however, two further moments of probability density functions i.e. skewness and kurtosis.
Different financial markets exhibit different, but not generally neutral, levels of skewness and kurtosis. Most
notably, many financial markets have probability density functions with fat tails. Crucially, this implies that
financial markets have many more extreme outcomes than that predicted by the use of standard deviation
alone.
For giving a true picture of the market implementation of those factors, the raw data for S&P, Treasury bond
and bill returns is collected from the Federal Reserve database in St. Louis (FRED). For the simplicity of the
measurement the 21 years data (from 1993-2013) is used which is given in the appendate part. Here, the
Treasury bill rate is a 3-month rate and the Treasury bond is the constant maturity 10-year bond, but the
Treasury bond return includes coupon and price appreciation. The key findings from this data is given bellow
in the table:
S&P T.Bill T.Bond
Mean 10.95% 2.83% 6.30%
Skew -0.875636246 -0.156033608 -0.209312213
Kurtosis 0.543464513 -1.641945982 -0.81701559
Excess Kurtosis -2.456535487 -4.641945982 -3.81701559
Standard Deviation 0.190461297 0.020880736 0.099946836
Table 01: Key statistical measures of different asset

S&P stocks skew and kurtosis: The mean of those
stocks is 10.95% for the last twenty one year and the
deviation of the returns from this average is 19.046%, which
means the return gain from S&P stocks is deviated 17. 046%
from this average return. The curve is having a longer tail in
the right side than the left. The skewed value of the S&P
stocks is found -.875636246 which is indicating a negative
scenario. That means the S&P stock may have given a
frequent small return in those twenty years, but had a
possibility of getting an extreme loss, which is indicating a
risky situation of negative outcome. On the other hand the
excess kurtosis of these stocks return is found .543464513
and the excess kurtosis is -2.456535487 which is a negative
value.As, the kurtosis is less than 3 so, the pick is less than
the normal distribution and as the value of the excess
kurtosis is negative, so it is a platykurtic distributions that
means there is less chances of high risks.



T-Bill skew and kurtosis: The mean for T-bill is 2.83%
and standard deviation is 2.08% which is indicating that
the T-bills return is more centered to 2.83%. The skewness
of those data is found - 0.156033608 which is indicating a
negative skew that means T-Bill return for the last twenty
one years is also exposed to frequent small return but a
possibility of getting an extreme loss. So, for the last
twenty years these return was also risky. In the case of
kurtosis the value is found-1.641945982 and the excess
kurtosis is- 4.641945982 which is indicating a negative or
platykurtic distributions. As, the value of kurtosis is less
than 3 so, it is lesser than the normal distribution and its
smaller, negative value indicating that it has more
frequent but less extreme risk of undesired outcome.

T-Bond skew and kurtosis: The mean of those bond
for the last twenty one years was 6.30% and the deviation
of the returns from this average is 9.99% that means the
return gain from T-Bond was deviated 9.99% from this
average return. The skewed value of the T-Bonds is found -
0.209312213 which is indicating that the bonds may have
given a frequent small return in those twenty years, but
had a possibility of getting an extreme loss, which is
indicating that the curve is having a longer tail in the right
side than the left. That results a risky situation of negative
outcome. On the other hand the kurtosis of these stocks
return is found -0.81701559 and excess kurtosis is -
3.81701559 which is a negative value. As, it is negative, so
it is a platykurtic distributions that means there is less
chances of high chance of risks.

From the overall analysis of these three types of assets the following issues have been derived with regards
to returns mean, standard deviation, skewness and kurtosis:
For the last twenty years the S&P has a higher average returns than T-Bill, and T-Bonds that is 10.95% >
2.83% 6.30%. But the actual return is more deviated from the average return for S&P than the other
assets, as it has the highest standard deviation of 19.06% in comparison with T-Bill and T-Bond.

The skewness for all assets i.e. S&P,T-Bill, T-Bond is derived negative, that means all of the curves has
long left tail, which for investors can mean a greater chance of extremely negative outcomes.

All of the assets considered here has a negative excess kurtosis that means all those assets returns has
lower and less distinct peak from the normal distribution, and they have less of the variability and a lots
of modest differences from the mean.

Fat tail Event:
A fat-tailed distribution is one of the so-called heavy-tailed statistical distributions that describe the
probability of certain events. A probability distribution with fat tails would be one in which moderately
extreme outcomes were more likely than one might have expected. The height of American women can be
taken as an example. This variable has close to a normal distribution with a mean of 64 inches and a standard
deviation of 3 inches. Based on the properties of a normal distribution, 95 percent of American women will
be between 58 and 70 inches tall. But if a women is found 132 inches, this is about 23 standard deviations
from the mean, which is an exceedingly small number for a normal distribution. In this case, we say that we
have witnessed a tail event and that the tail of the distribution is fat rather than medium as in the case of
the bell curve.
In economic markets, as in other social phenomena, classical theories generally expect some form of normal
distribution. When a portfolio of investments is put together, it is assumed that the distribution of returns
will follow a normal pattern. Under this assumption, the probability that returns will move between the
mean and three standard deviations, either positive or negative, is 99.97%. This means that the probability of
returns moving more than three standard deviations beyond the mean is 0.03%, or virtually nil. However, the
concept of tail risk suggests that the distribution is not normal, but skewed, and has fatter tails. The fatter
tails increase the probability that an investment will move beyond three standard deviations.
For instance, the distribution of monthly or daily market returns, including risks and volatilities, do not always
follow the normal law. When observed in a graph form, the curve becomes flatter and less bell shaped
giving the fat tails distribution; and with it more lower and higher instances of extreme values. The graph of a
fat tail event is given bellow:



To illustrate the problem of fat tails, it is helpful to first picture a probability distribution such as the common
bell curve or normal distribution. The normal distribution has most observations clustering around the
center. For example we can take the returns on the U.S. stock market. The monthly returns for stock prices
for the 140-year period from 1871 to 2010 were calculated and it is shown in the chart below:

Largest increase in 140 years
Actual 40.7
Normal distribution 14.3
Largest decrease in 140 years
Actual -30.8
Normal distribution -13.7

As shown in Table, the actual maximum and minimum increases are much larger than would be found with a
normal distribution. The maximum is a 10 sigma event, which would almost never happen with a normal
distribution.

The measures of Fat tail: Fat tail can be derived by the Pareto distribution law, where the probability of
an event is P = k1 X - (1+a), where a is the Pareto shape parameter, which reflects the importance of tail
events; X is the variable of interest; and k1 is a constant that ensures that the sum of probabilities is 1. Here
we can get two distinctive scenario:
If a is very small, then the tail is very fat and the variable has a highly dispersed distribution
If a gets larger, the tail looks more like a normal distribution


Applications of fat tail: There are many applications of the statistics of tail events. An interesting recent
one is earthquakes and tsunamis. It turns out that earthquake energy is a Pareto distribution with a very fat
tail (a Cauchy distribution in which a = 1). If earthquakes really follow this distribution, then the expected
value of earthquake power is unbounded. Another interesting application is finance. Stock price changes are
Paretian or power law. Here the expected value of the change is finite, but the variance is infinite. That
makes a derision of mean, variance analysis in portfolio theory and other theories which require a finite
variance of price changes.


Appending part

References:
http://eranraviv.com/blog/kurtosis-interpretation/ http://www.spcforexcel.com/are-skewness-
and-kurtosis-useful-statistics http://statistics.about.com/od/Descriptive-Statistics/a/What-Is-
Kurtosis.htm http://jalt.org/test/bro_1.htm
http://www.tc3.edu/instruct/sbrown/stat/shape.htm http://www.investopedia.com/exam-
guide/cfa-level-1/quantitative-methods/statistical-skew-kurtosis.asp
http://lexicon.ft.com/term?term=fat-tails http://www.investopedia.com/terms/t/tailrisk.asp
http://en.wikipedia.org/wiki/Kurtosis http://en.wikipedia.org/wiki/Skewness
http://www.itl.nist.gov/div898/handbook/eda/section3/eda35b.htm



















Appendix:


Table 01: Twenty one years data (1993-2013) for S&P, T-Bill, and T-Bond

Year S&P 500 T. Bill T. Bond
1993 9.97% 2.98% 14.21%
1994 1.33% 3.99% -8.04%
1995 37.20% 5.52% 23.48%
1996 22.68% 5.02% 1.43%
1997 33.10% 5.05% 9.94%
1998 28.34% 4.73% 14.92%
1999 20.89% 4.51% -8.25%
2000 -9.03% 5.76% 16.66%
2001 -11.85% 3.67% 5.57%
2002 -21.97% 1.66% 15.12%
2003 28.36% 1.03% 0.38%
2004 10.74% 1.23% 4.49%
2005 4.83% 3.01% 2.87%
2006 15.61% 4.68% 1.96%
2007 5.48% 4.64% 10.21%
2008 -36.55% 1.59% 20.10%
2009 25.94% 0.14% -11.12%
2010 14.82% 0.13% 8.46%
2011 2.10% 0.03% 16.04%
2012 15.89% 0.05% 2.97%
2013 32.15% 0.07% -9.10%



Table 02: Frequency distribution for S&P, T-Bill, and T-Bond

S&P500(Bin) Frequency T-Bill(Bin) Frequency T-Bond(Bin) Frequency
-65.23% 0 -5.52% 0 -33.68% 0
-46.18% 0 -3.43% 0 -23.68% 0
-27.14% 1 -1.34% 0 -13.69% 0
-8.09% 3 0.74% 5 -3.69% 4
10.95% 6 2.83% 4 6.30% 7
30.00% 8 4.92% 8 16.29% 7
49.05% 3 7.01% 4 26.29% 3
68.09% 0 9.10% 0 36.28% 0
87.14% 0 11.19% 0 46.28% 0
106.18% 0 13.27% 0 56.27% 0
125.23% 0 15.36% 0 66.27% 0
144.28% 0 17.45% 0 76.26% 0
163.32% 0 19.54% 0 86.26% 0
More 0 More 0 More 0

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