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Using Truncated Levy Flight to Estimate Downside Risk

Using Truncated Levy Flight to Estimate Downside Risk

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Published by: Pedro De Sá Menezes on Jun 22, 2010
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08/07/2010

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Using truncated Le´ vy flight toestimate downside risk
Received (in revised form): 2nd February, 2010
and is available online athttp://www.henrystewart.com/jrmfi.aspx
James X. Xiong
is a senior research consultant at Ibbotson Associates, a Morningstar company, in Chicago, Illinois.Ibbotson Associates, 22 West Washington Street, Chicago, IL 60602, USATel:
þ
1 (312) 384 3764; Fax:
þ
1 (312) 696 6701; E-mail: jxiong@ibbotson.com
Abstract
It is well known that the normal distribution model fails to describethe fat tails of markets. The Le´vy stable distribution model, meanwhile, has fattails but leads to an infinite variance, thus complicating risk estimation. Thisstudy introduces truncated Le´vy flight (TLF) — a better distribution model thathas fat tails, finite variance, and more importantly, scaling properties. The paperuses TLF to estimate the downside risk of a variety of asset classes. Thedownside risk measure used is the conditional value-at-risk (CVaR). The studyshows that the lognormal model can underestimate the monthly CVaR by 2.27per cent for the S&P 500 Index, 0.48 per cent for the US Long-Term GovernmentBond Index, and 1.16 per cent for the MSCI UK Equity Index. Moreover, the paperextends a univariate TLF model to a multivariate TLF model to study the impactof fat tails on portfolios’ downside risk and wealth accumulation.
Keywords 
truncated Le ´ vy flight, downside risk, conditional value-at-risk, fat tail 
INTRODUCTION
The most common model of asset returnsis assumed to be normally or Gaussiandistributed.
1
This model is natural if oneassumes the return over a time interval tobe the result of many small independentshocks, which leads to a Gaussiandistribution by the central limit theorem.The model provides a first-order approximation of the behaviour observedin empirical data. However, empiricalstudies have observed that the returndistributions are more leptokurtic or fat-tailed than Gaussian distributions.A normal distribution model assumesthat an asset return that is three standarddeviations below its arithmetic mean (athree-sigma event) has a probability of only
0.13 per cent, ie once every1,000 times. For example, from January1926 to April 2009, the S&P 500 TotalReturn Index had a monthly meanreturn of 0.91 per cent and a monthlystandard deviation of 5.55 per cent.Here, a negative three-sigma event wouldbe a return lower than –15.74 per cent.During this time period, there were tenmonthly returns worse than –15.74 per cent, as shown in Table 1. This impliesthat the probability of a three-sigmaevent is 1 per cent rather than 0.13per cent, or eight times greater thanone would expect under a normaldistribution. Hence, a normaldistribution fails to describe the ‘fat’or ‘heavy’ tails of the stock market.Many statistical models have been putforth to account for the heavy tails.
#
Henry Stewart Publications 1752-8887 (2010)
Vol. 3, 3
231–242
Journal of Risk Management in Financial Institutions 
231
 
Well-known examples are Mandelbrot’sLe´vy stable hypothesis,
2
the Student’s
-distribution,
3
and themixture-of-Gaussian distributionshypothesis.
4
The latter two modelspossess finite variance and fat tails, butthey are not stable, which implies thattheir shapes change at different timehorizons and that distributions atdifferent time horizons do not obeyscaling relations.An alternative is the Le´vy stabledistribution model.
5
In 1963, Mandelbrotmodelled cotton prices with a Le´vy stableprocess,
2
a finding later supported byFama in 1965.
6
A Le´vy stable distributionmodel has fat tails and obeys scalingproperties, but it has an infinite variancethat conflicts with empirical observationsthat the return variance is finite. Theinfinite variance would also complicatethe task of risk estimation.In the context of logarithm of assetreturns (plus 1), the correspondingmodels are the lognormal and log-stablemodels. Figure 1 illustrates the log-stableand lognormal distributions in fitting thedistribution of the monthly S&P 500returns (see also Martin, Rachev andSiboulet;
7
and Kaplan
8
). The vertical axisof Figure 1 is in log scale with a base of 10, and this helps to view the tails of thedistribution more clearly. It is clear thatthe lognormal distribution fails to fit thereturn distribution below 15 per cent(the abovementioned three-sigma event).The log-stable distribution fits the tailwell, but it extends far beyond thehistorical maximum loss or gain withnon-negligible probabilities, whicheventually results in an infinite variance.In other words, the tail for the log-stabledistribution is too fat.What is needed here is a model withdistribution somewhere between the
Table 1:
The ten worst monthly returns for theS&P 500 (January 1926 to June 2009)DateS&P500(%)Sep 1931
2
29.73Mar 1938
2
24.87May 1940
2
22.89May 1932
2
21.96Oct 1987
2
21.52Apr 1932
2
19.97Oct 1929
2
19.73Feb 1933
2
17.72Oct 2008
2
16.79Jun 1930
2
16.25
Source: Morningstar Encorr.
Figure 1:
The historical distributions of S&P 500 monthly returns fitted by the log-stable and lognormalmodels
Xiong 
232
Journal of Risk Management in Financial Institutions 
Vol. 3, 3
231–242
#
Henry Stewart Publications 1752-8887 (2010)
 
normal and stable distribution — that is,with an appropriately fat, but finite tail.The model in question is the truncatedLe´vy flight (TLF) model. In addition tohaving finite variance and fat tails, themodel obeys Le´vy stable scalingrelations at small time intervals andconverges slowly to Gaussiandistribution at very large time intervals,which is consistent with empiricalobservations. The TLF model isdiscussed in detail below.The return distribution models arecritical to estimates of downside risk.The lognormal distribution modelhas a thin left tail, and thus tends tounderestimate the downside risk.A popular downside risk measure isvalue-at-risk (VaR), which is an estimateof the loss that one would expectto be exceeded with a given level of probability over a specified time period.Conditional value-at-risk (CVaR) isclosely related to VaR and is derived bytaking a weighted average between theVaR and losses exceeding the VaR.CVaR is also called the ‘expected tailloss’. Previous studies (eg Rockafellar andUryasev
9
) have shown that CVaR hasmore attractive properties than VaR; for example, CVaR is a coherent measure of risk, as proved by Pflug.
10
The presentpaper therefore uses CVaR as a measureof downside risk.In the rest of the paper, the study firstshows that a univariate TLF model fitsmonthly return distributions for a varietyof asset classes represented by the S&P 500,Ibbotson US Long-Term GovernmentBond Index, and the Morgan StanleyCapital International (MSCI) UK EquityIndex very well. To estimate the downsiderisk for a portfolio more accurately, theunivariate TLF model is then extendedto a multivariate TLF model.
TRUNCATED LE´ VY FLIGHT
ATLF process is a stochastic process withfinite variance and fat tails. Theprobability density function (PDF) of asimple TLF process is defined as:
ð
x
Þ¼
0
;
x
,
À
;
ð
x
Þ¼
Levy
ð
x
Þ
;
À
x
;
ð
x
Þ¼
0
;
x
.
where
Levy
(x)
is the PDF of return
x
for a Le´vy stable distribution and
is thecutoff length for the truncation.Mantegna and Stanley
11,12
show that,for a small time interval (eg a minute),the TLF distribution approximates aLe´vy stable distribution with Le´vy stablescaling; while for a significantly large butfinite time interval (eg a year), the TLFdistribution slowly converges to aGaussian distribution. In other words,the TLF undergoes a crossover from aLe´vy stable distribution to a Gaussiandistribution as the time interval increases.This crossover is consistent with anindependent empirical study of thedistribution of daily, weekly and monthlyreturns for which a progressiveconvergence to a Gaussian process isdeemed to be observed.
13
Unfortunately, large time interval(such as annual) data are very limited.There are likely to be fewer than 100annual data points for a market index,which makes the test of convergence to aGaussian distribution statistically difficult.Previous studies have mostly focusedon high-frequency data such as dailyreturn data. Here, the aim is to fit themonthly data by the log-TLF modelbecause many investors have a relativelylong investment horizon and portfoliosare often rebalanced monthly.
Using truncated Le ´ vy flight to estimate downside risk 
#
Henry Stewart Publications 1752-8887 (2010)
Vol. 3, 3
231–242
Journal of Risk Management in Financial Institutions 
233

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