Managing extreme events in financial markets

Supporting Material

January 4, 2016

The skewness of a financial asset return r is the probability-weighted average of the cube of its
possible standardized values. For ∑nexample, if the possible values of r are r1 , r2 , ..., rn with associated
probabilities p1 , p2 , ..., pn with i pi = 1, then its skewness is given by the following equation

∑
n ( )3
ri − E[r]
SK [r] = pi .
V ol[r]
i=1

Since we standardize by computing the deviation of r to its expected value and then dividing by its
volatility, skewness is not affected by the location and scale of its distribution. The cube exponent
results in extreme returns having more impact on skewness.
The cube exponent also preserves the sign of the extreme values. A symmetric distribution, like
the normal distribution, has a skewness of zero as negative standardized returns are equally likely
as positive standardized returns of the same amplitude. Negative skewness indicates that negative
standardized returns of large amplitude are more likely than positive standardized returns of same
amplitude, and vice-versa.
The kurtosis coefficient is a measure of the likelihood of extreme returns, regardless of their
signs. Kurtosis is given by the following equation

∑
n ( )4
ri − E[r]
K [r] = pi .
V ol[r]
i=1

The normal distribution has a kurtosis of 3. Distribution with higher kurtosis than 3 are said to
be leptokurtic, or more commonly called in finance fat-tailed.