Fat Tails, Thin Tails, and Climate Change Policy

Fat Tails, Thin Tails, and Climate Change Policy

How much environmental damage would result from unabated water pollution, greenhouse gas (GHG) emissions, toxic waste disposal, and other potentially destructive activities? And whatever that environmental damage is expected to be, what economic and social cost will it have? In other words, what is the benefit of taking costly actions today or in the near future to reduce rates of pollution and...

Fat Tails

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Perpetuities with Thin Tails

Prospect theory and fat tails

A behavioral representative investor who evaluates a single risky asset based on cumulative prospect theory will often induce high kurtosis, negative skewness, and persistent autocorrelation into the distribution of market returns even if the asset payoffs are merely a sequence of independent coin tosses. These findings continue to hold even when the investor is simply loss averse.

Correlations have fat tails, too

The investment community is, by now, familiar with the idea of fat tails. The concept moved beyond the domain of actuaries and quant geeks with Nassim Nicholas Taleb’s book The Black Swan (2007). Taleb drove home the point that volatility does not tell the whole story of the uncertainty associated with asset returns. In particular, extreme outcomes occur more frequently (i.e., tails are fatter)...