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Skewness Kurtosis Financial Markets

Skewness Kurtosis Financial Markets

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Chasing the Elusive Pearson Distribution: Skewness and Kurtosis in Financial Markets

Artemis Econometrics, LLC www.artemis-econometrics.com info@artemis-econometrics.com

Draft submitted for comments July 8, 2013. © 2013 Artemis Econometrics, LLC. All rights reserved.

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Contents
Introduction ..................................................................................................................................... 3 The Normal Distribution ................................................................................................................. 3 The Pearson Type IV Distribution .................................................................................................. 5 Probability Density Function .......................................................................................................... 6 Parameter Estimation ...................................................................................................................... 7 Recent Research .............................................................................................................................. 8 Application to Daily Returns .......................................................................................................... 9 Statistical Significance of Pearson Parameters ............................................................................. 11 Application to Regression Analysis .............................................................................................. 12 Comparison to Robust Regression ................................................................................................ 14 Conclusion .................................................................................................................................... 16 Tables ............................................................................................................................................ 17 Figures........................................................................................................................................... 19 References ..................................................................................................................................... 22

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although proper use of the PearsonIV distribution requires a thorough understanding of the strengths and potential pitfalls of its plasticity. Most prominently. forms the centerpiece for many tools in investment management. integrating skewness and kurtosis into time series analysis remains a difficult task. The results are encouraging. This study describes the PearsonIV distribution. and uses it as a basis for regression analysis. and researchers have recently applied several PearsonIV methodologies to financial markets. asymmetric. fat-tailed Pearson Type IV (henceforth PearsonIV) distribution. examines its out-of-sample predictive properties. The Normal Distribution The normal distribution. the normal distribution’s standard deviation is the most common numerical representation of risk in financial markets. there has been compelling evidence that asset returns are not normally distributed but rather are subject to tendencies in direction (skewness) and extremal events (kurtosis). 3 .Introduction For at least half a century. Despite the general awareness that market returns do not follow a normal distribution. Important mathematical and programming developments have made the PearsonIV distribution accessible to a wider audience. One intriguing possibility for combining skewness and kurtosis with traditional mean and variance is the flexible. a continuous probability distribution defined by mean and variance.

Campbell. The normal distribution is symmetric around its mean. The normal distribution also has “thin tails.Despite its widespread use. For instance. but asset returns often seem to occur more frequently in one direction. Lo and MacKinlay (1997) cite several decades of overwhelming evidence that financial returns exhibit high kurtosis. there is a general understanding that the normal distribution’s mean and variance do not adequately explain the dispersion of returns on financial markets. 4 . There are conventional measures of the asymmetry of returns (skewness) and the relative probability of events outside the norm (kurtosis). Both skewness and kurtosis have been studied extensively.” meaning it ascribes a relatively low probability to large returns in either direction. The shortcomings of the normal distribution are especially apparent when extreme returns occur more frequently than would be predicted by the distribution’s thin tails.

Integrating skewness and kurtosis with ordinary mean and variance has been challenging. the PearsonIV is symmetric and becomes a Student’s . analogous to standard deviation. The PearsonIV distribution is defined by four real numbers ( other to offer a wide range of shapes and sizes. When limit. Most of these efforts were eventually abandoned. The creating thicker tails. The specifies the ) that interact with each variable is a measure of scale.” and has recently received attention for its potential application to financial markets. Campbell. suggesting that the Student’s distribution and mixtures of distributions are worthy of further study. The value of symmetry of the distribution. Campbell. the PearsonIV becomes an asymmetric Cauchy distribution. 5 . The parameter is a location metric similar to the mean of a normal distribution. Lo and MacKinlay recount a long history of attempts to apply non-normal probability distributions to financial time series. the PearsonIV approaches the normal distribution in the . with smaller values of The range of possible shapes is so expansive that the PearsonIV actually encompasses other distributions. parameter determines kurtosis. The fourth distribution has “unlimited range in both directions and skewness. Lo and MacKinlay end their narrative in the late 1990s. When and . Karl Pearson defined a collection of curves that became known as the Pearson family of distributions. The Pearson Type IV Distribution In 1895. When distribution.

Probability Density Function The PearsonIV probability density function (PDF) is: ( ) [ ( ) ] [ ( )] ( ⁄ ) (1) The PDF. Moreover. it requires a gamma function that can manipulate a complex number. Particle physicist Joel Heinrich (2004) provides a major advancement.. 6 . and nearly all equations and descriptions of the PearsonIV distribution in this study come from Heinrich’s work. which most statistical packages do not provide. The difficulty in calculating likely impeded the use of the PearsonIV distribution for over a century. However. and .e. require a normalizing constant that depends on the values of . Heinrich reformulates the most problematic part of the normalizing constant in terms of the hypergeometric function and provides sample code to calculate . Heinrich also defines the PearsonIV cumulative distribution in terms of the hypergeometric function and offers programming routines to generate random numbers from the PearsonIV distribution. The orthodox form of the PearsonIV normalizing constant works in complex numbers (i. numbers that have an imaginary component defined as the square root of -1). and the likelihood function to be examined later. This study uses C++ code modified from Heinrich’s example to compute . Nagahara (1999) uses an infinite multiplication series. this is probably too burdensome for routine analysis. To avoid the complex gamma function.

5. . .Parameter Estimation To determine the PearsonIV parameters . . (5) is used as an abbreviation for ( It is usually preferable to estimate the parameters jointly by minimizing the negative log likelihood: ∑ [ ( ) ] ∑ ( ) (6) Transforming the PearsonIV parameters . and . denoted by ̅ . variance. be at least 1. skewness and kurtosis of the series .0. skewness and kurtosis requires that on the data set. and . From these. PearsonIV estimates are: ( ) ( √ ( ( ) ) ( ) (2) ) ( ( ) ) ] (3) √ [ (4) ̅ Note that ( ) √ ). respectively. 7 .0 and 2. 1. the variance. Depending may preclude solutions that might otherwise be chosen. 2. these constraints on and into traditional mean. one first calculates the mean.5.

which has also been used to model skewness and kurtosis simultaneously. Premaratne and Bera (2001) suggest that compared to the Student’s distribution. the PearsonIV has heavier tails and can account for skewness. This approach is applicable to very long time series and allows the shape of the PearsonIV distribution to change through time within a data set. while the “PearsonIV model suggests that excess kurtosis rather than skewness should be accounted for. This minimal constraint should not be restrictive for financial data.” Yan (2005) shows that the PearsonIV distribution has a much larger range of skewness and kurtosis combinations than the Gram-Charlier distribution. Grigoletto and Lisi (2009) propose a dynamic. Grigoletto and Lisi (2007) and Bhattacharyya. Recent Research The PearsonIV distribution has attracted significant attention in recent years. Brännäs and Nordman (2003) add to an established record of tests rejecting the normal distribution when applied to financial returns. They also advise that the PearsonIV “is much easier to handle” than other asymmetric possibilities such as the non-central and the Gram-Charlier distributions. must be greater than 0.If an analysis only uses the PearsonIV distribution. They find that the one-parameter log-generalized gamma distribution indicates skewness in financial data.5. 8 . Misra and Kodase (2009) apply the PearsonIV distribution to value-at-risk analysis. time-varying PearsonIV model in which the parameters are defined by nine GARCH coefficients.

The numbers along the axis do not indicate actual probabilities.g. The hashed line signifies the PearsonIV distribution fit to the same data. without the intervening GARCH filter used by Grigoletto and Lisi.. these curves denotes the relative probability of observing a return at any point along the The axis has a high scaling because the axis.22%. calculating standard deviation or skewness from a relatively small sample of recent returns). fit to one year of daily returns. The standard deviation of daily returns over the previous year was 2. has a small scaling. This approach is robust even with small data sets and reflects what many financial professionals do in practice (e. Nikolaidis and Zarangas (2012) use the PearsonIV model for valueat-risk analysis. especially at the high confidence levels.14%. and its mean daily return was -0. Makris. This example takes place during the financial crisis. The parameters are therefore constant throughout the estimation time frame.Stavroyiannis. and the area under each curve must sum to one. The solid line represents the normal distribution of an S&P 500 exchange traded fund (ETF) on October 31. when the stock market witnessed some of the largest volatility in its history. the height of axis. providing a very good candidate as an alternative distributional scheme.” Application to Daily Returns This study models the PearsonIV parameters directly from the data. compared with the skewed student [t] distribution. and find that “the PearsonIV distribution gives better results. 2008. Figure 1 demonstrates this method in practice. representing daily returns. 9 . Rather.

meaning it has a density that is too low around its center.28% return of the S&P 500 ETF on the next trading day. Therefore. Table 1 presents the results of this 10 .The solid line drawn upward from the horizontal axis corresponds to the 0. However. where the probability might actually be quite low. the normal distribution is not able to put enough weight in its tails to match the PearsonIV distribution’s kurtosis. The PearsonIV distribution allows for a much higher probability of the November 3 return than does the normal distribution. This dramatic example illustrates the potential costs of applying a normal distribution to non-normal financial series. there are significant negative consequences. In contrast. The PearsonIV distribution is able to form a shape that has a very dense section around the mean but also thick tails. The normal distribution expands outward in an attempt to account for the extreme volatility of the S&P 500 index during this time.28%. such as the November 3 return of 0. An exercise of this sort can indicate whether one distribution is consistently more effective at accounting for the observed return pattern. It therefore attributes a relatively low probability to events occurring around its mean. The normal distribution would be more effective if there were more probability weight directly in the middle and on the tails. 2008. The and symbols reflect the relative likelihood of this return given the probability densities derived from daily returns over the prior year. November 3. significant density weight in the normal distribution is shifted to intermediate areas. Financial returns tend to have frequent returns around zero and occasional extreme returns. Moreover. the bulky middle section of the normal distribution stretches along the axis. Simply increasing the variance of a normal distribution does not change its nature as a thin-tailed probability density.

who find that the kurtosis parameter is more significant than the skewness parameter when the PearsonIV distribution is applied to equity returns. Inc.. as demonstrated in Figure 1.exercise repeated every trading day. but this is because most of the time there is little difference between the normal and PearsonIV distributions. 11 . Table 1 indicates that in all cases the PearsonIV distribution offered a relative advantage in fitting a collection of ETFs and hedge fund indices.1 The results may seem marginal. the probability densities of the normal and PearsonIV distributions are calculated using daily returns from the previous year. from January 2000 to March 2013. The results are consistent with Brännäs and Nordman (2003). This means that even though returns are mostly negative. Inc. 1994). during a market sell-off. © 2013 Hedge Fund Research. These densities are then compared to each other using the next day’s actual return. The PearsonIV parameters are estimated jointly. when they are positive they are larger in the positive direction. but a positive skew. It is possible for the PearsonIV to have a negative mean. and these results are summed through time.com.hedgefundresearch. Statistical Significance of Pearson Parameters Figure 2 shows rolling statistics of the PearsonIV evaluated for an S&P 500 ETF using three years of weekly data. The statistics are based on variance estimates taken from the negative inverse of the matrix of numerical partial second derivatives (Hamilton. All rights reserved. This 1 Source: Hedge Fund Research. data permitting. Not only is the symmetry parameter the least significant statistically. the sign remains positive even during the financial crisis of 2008. www. They tend to diverge substantially during high market volatility. At each point. so symmetry is defined relative to the location parameter .

and the interpretation of skewness can be counterintuitive when it is defined relative to a mean. Although the concept of skewness has a compelling appeal. Skewness tends to be less statistically significant than kurtosis. respectively (Wikipedia: List of largest daily changes in the S&P 500). the statistical results can be ambiguous. Ordinary least squares (OLS) regression takes the form: ( ) (7) A PearsonIV regression is defined as: ( ) (8) 12 .93% and 10. Application to Regression Analysis Regression analysis presents a potentially useful application of the PearsonIV distribution. which have long been used to minimize the effects of outlier data points on the regression coefficients. Allowing regression residuals to have a PearsonIV distribution would not only account for outliers.79% increases on October 13 and October 31. The concept is similar to robust regressions. 2008. for the two largest daily percentage gains in the history of the S&P 500 index were 9. rather than with respect to zero. it would also help to keep systematic distortions in the shape of the residuals’ distribution from affecting the coefficients.is what happened during this time.

The PearsonIV residuals are allowed to have an off-center mean with a non-normal shape. Figure 3 shows rolling OLS and PearsonIV beta estimates using the Hedge Fund Research HFRX Global Hedge Fund Index2 as the dependent ( ) variable. Inc. © 2013 Hedge Fund Research. Inc. 3 This Hedge Fund Research. and an S&P 500 ETF as the independent ( ) variable. two explanations for the decreasing S&P 500 beta are that investors shifted to lower-volatility strategies.3 The OLS beta does not fully reflect changes in the portfolio until observations at the beginning of the financial crisis drop out of the data set. while the PearsonIV residuals are allowed a non-zero mean and non-normal shape. the PearsonIV regressions can take a more flexible approach. both the S&P 500 and the hedge fund index had negative returns.. Therefore. All rights reserved. or the underlying hedge funds reduced equity holdings. Both regressions use two-year rolling windows of weekly data and include one lag term.com.hedgefundresearch. The OLS residuals are normally distributed with zero mean. In an OLS regression. During the financial crisis. 2010. The most striking result is how quickly the PearsonIV model was able to react to the decreasing equity exposure of this hedge fund index after the 2008 financial crisis. In contrast. www. The residuals show why the PearsonIV regressions are much quicker to respond to the changing market exposure of the hedge funds. As more observations appear indicating the hedge funds have decreased their S&P 500 beta. 13 . the PearsonIV 2 Source: Hedge Fund Research.. regressions. Figure 4 displays the distributions of the residuals from the January 29. index is asset weighted based on the total assets of each strategy in the hedge fund universe. The difference in the coefficients results from the heavy weight the PearsonIV distribution puts into the negative tail. those two sets of negative returns are aligned with each other and attributed to the coefficients as long as the observations are in the sample. Inc.

This result is notable because several complicated methods have been proposed to model hedge fund returns in a manner that responds quicker to changes in the underlying portfolio than rolling OLS regressions. while the PearsonIV beta may represent a more realistic assessment of direct equity exposure in the hedge fund index. This hedge fund index includes a broad range of investment styles. not just equities. It is possible that the OLS coefficient reflects the correlations of multiple well-performing strategies. including low-volatility absolute return strategies that should have little discernible equity exposure. Here. even in the context of rolling regressions. Robust regressions iteratively reweight the observations to generate coefficient estimates that are not heavily influenced by outlier data 14 .50 could be too high for a diversified index of this sort. The OLS beta above 0. One other major difference between the OLS and PearsonIV regressions in Figure 3 is that the PearsonIV model results in lower S&P 500 betas during the steadily rising market up to mid2008. The negative returns of the hedge fund index then become negative residuals and show up as weight on the left-hand side of the residuals’ distribution. Hedge funds were posting positive returns during this time because numerous asset classes were rising.approach allows itself to unlink the negative returns of the index and the S&P 500 ETF that occurred at the beginning of the financial crisis. Comparison to Robust Regression The conceptual difference between the OLS and PearsonIV regressions is similar to the difference between OLS and robust regressions. the PearsonIV model is able to accomplish this in a very natural way.

The PearsonIV regression model theoretically could account not only for unusual data points but also for abnormal shapes in the distribution of the data. However. because they indicate the PearsonIV regression model might be an attractive option to handle data that contain outliers or have odd distributions. 15 . it does not provide as much improvement as the PearsonIV method. There are several types of robust regressions. The OLS regression is unable to recover from these outliers. while a higher out-of-sample R-squared is better. Table 2 presents the results of this exercise applied to a broad array of hedge fund indices. Figure 5 presents a comparison of the OLS. The robust regression handles the outliers more effectively than OLS. This exercise uses the Huber robust beta that is the first option in James P.points. and gives a beta estimate closer to its true value. PearsonIV and robust regression methods. This example is not comprehensive enough to draw broad conclusions regarding the efficacy of the PearsonIV approach versus robust regressions. The study takes a hedging perspective: lower mean absolute deviations and root mean squared errors are better. and they have different tolerance settings. and the OLS beta is too low as long as those data points remain in the sample. the robust approach produces erratic results over other parts of the sample. the results are encouraging. LeSage’s MATLAB econometrics toolbox. Furthermore. The Russell 2000 Value ETF return series contains several observations at the beginning of the financial crisis that distort its true beta to the S&P 500. while the PearsonIV coefficients remain stable. However. The goal of robust regressions is to produce coefficients that reflect the common relationship between variables since they are not pulled in the direction of atypical or extreme events.

offer more accurate and stable coefficient estimates than OLS or robust regressions. especially equity returns. Early indications from this and other works show the PearsonIV distribution has both the flexibility and robustness to compensate for limitations of the normal distribution.Conclusion Convincing evidence over an extended time shows that the mean and standard deviation of the normal distribution do not properly describe the dispersion of asset returns. 16 . The PearsonIV distribution offers an intriguing possibility for integrating mean. regressions with PearsonIV residuals may. skewness and kurtosis in a coherent framework that allows a great deal of flexibility in modeling asset returns. it could someday become an important addition to the toolkit of academic researchers and financial professionals. Furthermore. under certain circumstances. variance. If future research continues to demonstrate the value of the PearsonIV distribution. This study provides evidence that the PearsonIV distribution can be more effective than the normal distribution at modeling the unconditional returns of a range of ETFs and hedge fund indices.

060 1. ** 17 .135 1.151 1.064 1.033 1.065 1..com. www.072 1.190 1. Inc.072 1.Tables Table 1 Relative Fit of Pearson Type IV and Normal Distributions Study Size (Daily Data) 3329 3329 3212 3329 3329 3091 3184 3179 3227 3227 3184 3184 3184 3184 3184 2361 2912 2505 Relative Fit (Pearson Type IV / Normal)* 1.041 1.035 Exchange Traded Fund SPDR S&P 500 PowerShares QQQ iShares Dow Jones US Real Estate Financial Select Sector SPDR Energy Select Sector SPDR iShares S&P Global 100 Index iShares Russell 3000 Growth Index iShares Russell 3000 Value Index iShares Russell 1000 Growth Index iShares Russell 1000 Value Index iShares Russell 2000 Growth Index iShares Russell 2000 Value Index iShares S&P SmallCap 600 Growth iShares S&P SmallCap 600 Value Index iShares S&P Europe 350 Index iShares Dow Jones Select Dividend Index iShares MSCI EAFE Index iShares MSCI Emerging Markets Index Ticker SPY QQQ IYR XLF XLE IOO IWZ IWW IWF IWD IWO IWN IJT IJS IEV DVY EFA EEM HFRX Hedge Fund Index** Convertible Arbitrage Relative Value Arbitrage Market Directional Macro/CTA Global Hedge Funds Event Driven Equity Hedge Equal Weighted Strategies Equity Market Neutral Merger Arbitrage Absolute Return * Identifier HFRXCA HFRXRVA HFRXMD HFRXM HFRXGL HFRXED HFRXEH HFRXEW HFRXEMN HFRXMA HFRXAR Study Size (Weekly Data) 521 521 456 521 521 521 521 521 521 521 456 Values greater than one indicate relative advantage to Pearson Type IV.hedgefundresearch. © 2013 Hedge Fund Research.075 1.069 Relative Fit (Pearson Type IV / Normal) 1.073 1.057 1.027 1.055 1. All rights reserved. Source: Hedge Fund Research.048 1.070 1.059 1.068 1.059 1.066 1.030 1.067 1.032 1.145 1.031 1.104 1. Inc.

35 0.76 0.22 1.58 0.47 0.77 1.68 0.68 0. Inc.13 0.66 0.04 1.99 2.57 21.04 1. www.96 6.33 0.80 0.46 Pearson IV 16.29 0.32 Robust Regression 1.60 0.80 0.hedgefundresearch.56 0.88 1..81 0.44 OLS 8.10 41.71 Robust Regression 0.93 60.80 0.40 0.88 52.34 0.68 34.65 0.11 0.68 0.97 1.02 5.48 Robust Regression 9.90 49.31 Pearson IV 1.76 37.81 0. All rights reserved.64 0.41 0.03 32.74 43.59 0.83 0.68 60.53 48.39 34.50 59.38 0.96 1.48 0.02 35.59 0.78 0.84 21.47 0.70 0.85 0.42 0.61 0.45 0.45 0.Table 2 Regression Performance: HRFX Hedge Fund Indices* Hedged with S&P 500 ETF Mean Absolute Deviation (weekly %) Convertible Arbitrage Relative Value Arbitrage Market Directional Macro/CTA Global Hedge Funds Event Driven Equity Hedge Equal Weighted Strategies Equity Market Neutral Merger Arbitrage Absolute Return Root Mean Squared Error (weekly %) Convertible Arbitrage Relative Value Arbitrage Market Directional Macro/CTA Global Hedge Funds Event Driven Equity Hedge Equal Weighted Strategies Equity Market Neutral Merger Arbitrage Absolute Return Out-of-Sample R-Squared (%) Convertible Arbitrage Relative Value Arbitrage Market Directional Macro/CTA Global Hedge Funds Event Driven Equity Hedge Equal Weighted Strategies Equity Market Neutral Merger Arbitrage Absolute Return * OLS 0.68 0.52 0.21 0.71 35.51 0.62 0. © 2013 Hedge Fund Research.63 0.53 0.65 0.74 47.23 42.52 2.33 53.70 4. 18 .54 0.72 Source: Hedge Fund Research.48 0.51 22.31 OLS 1.55 0.65 0.36 0.67 0.48 0.21 Pearson IV 0. Inc.35 0.34 0.79 3.com.69 0.13 52.43 0.

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” Quantitative Finance. John Y. University of Illinois at Urbana-Champaign. and Bharat Kodase. University of Padua. 2001. Matteo and Francesco Lisi. Tech. Hamilton. Pearson. Bera. 22 . no. Yuichi. Time Series Analysis. 8: 925–935.” International Review of Financial Analysis. Brännäs. 2012.” Working Paper. Vasilis N. 1999. Premaratne. Princeton. Karl. vol. 2009.” Applied Economics Letters. Kurt and Niklas Nordman. Nagahara. Department of Statistical Sciences. “The PDF and CF of Pearson Type IV Distributions and the ML Estimation of the Parameters. Heinrich. “Modeling Asymmetry and Excess Kurtosis in Stock Return Data. NJ: Princeton University Press. Elsevier vol. “Contributions to the Mathematical Theory of Evolution II: Skew Variation in Homogeneous Material. 9. Lo and Archie Craig MacKinlay. series A. vol. NJ: Princeton University Press. Joel. 2009. 1997. vol. Campbell. 2007. “A Guide to the Pearson Type IV Distribution. The Econometrics of Financial Markets. Grigoletto. 22 (C): 10-17. Nityanand Misra. Princeton. Makris. “Econometric Modeling and Value-at-Risk Using the Pearson Type-IV Distribution. James D.” Working paper 01-0118.” University of Pennsylvania.” Philosophical Transactions of the Royal Society of London. 10: 725–728. 186: 343–414. “Looking for Skewness in Financial Time Series. Matteo and Francesco Lisi. Stavros.. “MaxVaR for Non-Normal and Heteroskedastic Returns. CDF/Memo/Statistics/Public/6820. College of Business. Gamini and Anil K. 1994. 1895. Andrew W. vol. Rep. 43 (July): 251– 264. 2003.References Bhattacharyya. Malay. Philadelphia. Ilias A. “Conditional Skewness Modelling for Stock Returns. Elsevier vol. 2004.” Statistics & Probability Letters.” The Econometrics Journal. “Value-at-Risk Prediction by Higher Moment Dynamics. Stavroyiannis. Grigoletto. Nikolaidis and Leonidas Zarangas. 12: 310–323.

Wikipedia contributors.org/wiki/List_of_largest_daily_changes_in_the_S%26P_500. Accessed May 31.” Wikipedia. Fat-tail. “List of largest daily changes in the S&P 500. Jun. University of Iowa. “Asymmetry. 2013.” Working paper 355. 23 . and Autoregressive Conditional Density in Financial Return Data with Systems of Frequency Curves. 2005. The Free Encyclopedia. Department of Statistics and Actuarial Science. http://en. Yan.wikipedia.

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