The Financial Crisis : Conventional Financial Theories

800 WordsNov 2, 20154 Pages
Following the 2008 Financial Crisis, conventional financial theories have been challenged for their inability to realistically explain risk. Traditional strategies of asset pricing often rely on a normal bell curve to make market assumptions, but in reality, the markets do not behave this way. Under a normal distribution, a majority of asset variation falls within 3 standard deviations of its mean which subsequently understates risk and volatility. Unfortunately, history would suggest financial markets do not always act in this manner and rather, they exhibit fatter tails than traditionally predicted. By definition, fat tails are a statistical phenomenon exhibiting large leptokurtosis. This represents a greater likelihood of extreme events occurring similar to the financial crisis. Since the magnitude of fat tails are so difficult to predict, left tail events can have devastating and unexpected effects on portfolio returns. As a result, sufficiently protecting a portfolio requires tail risk hedging from unexpected market events. Normal Distribution In order to understand the significance of tail risks, it is imperative to understand the notion of a normal distribution and its shortcomings. A normal distribution assumes that given enough observations, all values in the sample will be distributed equally above and below the mean. About 99.7% of all variation falls within three standard deviations of the mean and therefore there is only a .3% chance of an extreme event

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