Excess Kurtosis and Its Impact on Investment Researchers

Excess Kurtosis: A Challenge for Investment Researchers

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Question

Excess kurtosis is a problem for investment researchers using normal distributions because:

Answers

A. The likelihood of extreme outcomes will be overestimated.

B. Historical returns are better modeled with platykurtic distributions.

C. It is difficult to calculate.

D. The likelihood of extreme outcomes will be underestimated.

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Explanations

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A. B. C. D.

Historical returns are better modeled with fat-tailed (or leptokurtic) distributions, not platykurtic ones. If a researcher uses a normal distribution to model a fat-tailed distribution, the estimated probability of an extreme outcome will be underestimated. Thus, the frequency of market crashes will be underestimated, an underestimation of the volatility risk.

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