Fat tails arise endogenously from supply/demand, with or without jump processes

DOI10.3934/MATH.2021283zbMATH Open1484.91312arXiv2011.08275OpenAlexW3133763896MaRDI QIDQ2133227FDOQ2133227

Authors: Gunduz Caginalp 

Publication date: 29 April 2022

Published in: AIMS Mathematics (Search for Journal in Brave)

Abstract: We show that the quotient of Levy processes of jump-diffusion type has a fat-tailed distribution. An application is to price theory in economics. We show that fat tails arise endogenously from modeling of price change based on an excess demand analysis resulting in a quotient of arbitrarily correlated demand and supply whether or not jump discontinuities are present. The assumption is that supply and demand are described by drift terms, Brownian (i.e., Gaussian) and compound Poisson jump processes. If $P^{-1}dP/dt$ (the relative price change in an interval $dt$) is given by a suitable function of relative excess demand, $left(mathcalD\mathrm{\%}-mathcalSight)/mathcalS$ (where $mathcalD$ and $mathcalS$ are demand and supply), then the distribution has tail behavior $Fleft(xight)sim{x}^{-zeta}$ for a power $zeta$ that depends on the function $G$ in $P^{-1}dP/dt=Gleft(mathcalD/mathcalSight)$. For $Gleft(xight)simleftvertxightver{t}^{1/q}$ one has $zeta=q.$ The empirical data for assets typically yields a value, $zetailde=3,$ or $zetainleft[3,5ight]$ for some markets. The discrepancy between the empirical result and theory never arises if one models price dynamics using basic economics methodology, i.e., generalized Walrasian adjustment, rather than the usual starting point for classical finance which assumes a normal distribution of price changes. The function $G$ is deterministic, and can be calibrated with a smaller data set. The results establish a simple link between the decay exponent of the density function and the price adjustment function, a feature that can improve methodology for risk assessment. The mathematical results can be applied to other problems involving the relative difference or quotient of Levy processes of jump-diffusion type.

Full work available at URL: https://arxiv.org/abs/2011.08275

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zbMATH Keywords

fat tailsjump discontinuitiesasset price dynamicsquotient of Levy jump-diffusion processesstochastic pricessupply and demand functions

Mathematics Subject Classification ID

Probability distributions: general theory (60E05) Exact distribution theory in statistics (62E15) Applications of Brownian motions and diffusion theory (population genetics, absorption problems, etc.) (60J70) Asymptotic distribution theory in statistics (62E20) Microeconomic theory (price theory and economic markets) (91B24) Stochastic models in economics (91B70) Jump processes on general state spaces (60J76)

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Cited In (4)

• Price equations with symmetric supply/demand; implications for fat tails
• The quotient of normal random variables and application to asset price fat tails
• Alternative statistical specifications of commodity price distribution with fat tail
• On the concentration of large deviations for fat tailed distributions, with application to financial data

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