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

DOI10.3934/MATH.2021283MaRDI QIDQ2133227zbMATH OpenOpenAlexFDO

Authors Gunduz Caginalp

Publication date 29 April 2022

Published in AIMS Mathematics (Search for Journal in Brave)

Copyright license Creative Commons Attribution 4.0 International

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

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)

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.

Recommendations

• Price equations with symmetric supply/demand; implications for fat tails
• scientific article; zbMATH DE number 1281927
• On the origin of power-law tails in price fluctuations
• Fat tails and bubbles in a discrete time model of an inefficient financial market
• Alternative statistical specifications of commodity price distribution with fat tail
• The origin of fat-tailed distributions in financial time series
• Exogenous and endogenous price jumps belong to different dynamical classes
• From short to fat tails in financial markets: a unified description
• scientific article; zbMATH DE number 5249361

Cites work

• scientific article; zbMATH DE number 3117699 (Why is no real title available?)
• scientific article; zbMATH DE number 3164156 (Why is no real title available?)
• A kinetic thermodynamics approach to the psychology of fluctuations in financial markets
• A mathematical model for asset pricing
• Agent-based simulation of a financial market
• Asset flow and momentum: deterministic and stochastic equations
• Combinatorial auction design
• Density of the Ratio of Two Normal Random Variables and Applications
• Equilibrium price paths in sequential auctions with stochastic supply
• Fat tails and volatility clustering in experimental asset markets
• Fat tails, VaR and subadditivity
• Financial Modelling with Jump Processes
• Financial modelling applying multivariate Lévy processes: new insights into estimation and simulation
• Hedging Pressure and Futures Price Movements in a General Equilibrium Model
• Heterogeneous beliefs and routes to chaos in a simple asset pricing model
• Institutional Investors and Stock Market Volatility
• Introduction to Econophysics
• Multiscale stochastic volatility for equity, interest rate, and credit derivatives.
• On the distribution of quotient of random variables conditioned to the positive quadrant
• On the existence of a normal approximation to the distribution of the ratio of two independent normal random variables
• Price dynamics in an exchange economy
• Price equations with symmetric supply/demand; implications for fat tails
• Price formation in double auctions
• Stochastic gradient learning in the cobweb model
• The competitive market paradox
• The method of endogenous gridpoints for solving dynamic stochastic optimization problems
• The multivariate normal distribution
• The pricing of options and corporate liabilities
• The quotient of normal random variables and application to asset price fat tails
• The structure of bivariate Poisson distribution
• Theory of Financial Risk and Derivative Pricing

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

This page was built for publication: Fat tails arise endogenously from supply/demand, with or without jump processes

Report a bug (only for logged in users!)Click here to report a bug for this page (MaRDI item Q2133227)