Faculty of Business Administration

Financial Crises and Heavy-Tailed Stable Distributions

Prof. J. Huston McCulloch
Professor Emeritus of Economics and Finance
Ohio State University, USA


Financial economists often make the over-simplifying assumption that financial asset returns have finite variances, and therefore tend to be approximately Gaussian (or normal) when aggregated. This has led them, using the logic of the Black-Scholes model, to underestimate the probability of financial crises, to wrongly believe that risk can be perfectly arbitraged away, and to greatly undervalue far out-of-the-money contingent claims. In fact, the tails of the distribution of asset returns are far too heavy to be consistent with the Gaussian distribution. However, the Generalized Central Limit Theory leads to a natural generalization of the Gaussian distribution called the Stable class of distributions, put forward in the early 1960s by Benoit Mandelbrot and Eugene Fama. Paul Samuelson and Robert Merton were attracted to this class, but then were stumped by the problem of pricing assets and options when log prices are stable. The present paper provides a tractable solution to this problem that accounts for the “volatility smile” in market option prices.

Date: October 13, 2014 (Monday)

Time: 15:00~16:30

Venue: Faculty of Business Administration, E22-1008

A Short Biography of Prof. J. Huston McCulloch
Prof. J. Huston McCulloch is Professor Emeritus of Economics and Finance at the Ohio State University. He has been a Research Fellow at the National Bureau of Economic Research, and formerly edited the Journal of Money, Credit, and Banking. He has published extensively on Monetary Policy, the Term Structure of Interest Rates, heavy-tailed Stable Distributions, and other areas of economics and finance. He currently resides in New York City, and is an Adjunct Professor at New York University.