On Rational Bubbles and Fat Tails & Dragon-Kings, Black Swans and the Prediction of Crises

On Rational Bubbles and Fat Tails Abstract (Via SSRN) Click Here To Read The Paper

This paper addresses the statistical properties of time series driven by rational bubbles a la Blanchard and Watson (1982). Using insights on the behavior of multiplicative stochastic processes, we demonstrate that the tails of the unconditional distribution emerging from such bubble processes follow power-laws (exhibit hyperbolic decline). More precisely, we find that rational bubbles predict a fat power tail for both the bubble component and price differences with an exponent m smaller than 1. The distribution of returns is dominated by the same power-law over an extended range of large returns. Although power-law tails are a pervasive feature of empirical data, these numerical predictions are in disagreement with the usual empirical estimates. It, therefore, appears that exogenous rational bubbles are hardly reconcilable with some of the stylized facts of financial data at a very elementary level.

Dragon-Kings, Black Swans and the Prediction of Crises Abstract (Via SSRN) Click Here To Read The Paper

We develop the concept of “dragon-kings” corresponding to meaningful outliers, which are found to coexist with power laws in the distributions of event sizes under a broad range of conditions in a large variety of systems. These dragon-kings reveal the existence of mechanisms of self-organization that are not apparent otherwise from the distribution of their smaller siblings. We present a generic phase diagram to explain the generation of dragon-kings and document their presence in six different examples (distribution of city sizes, distribution of acoustic emissions associated with material failure, distribution of velocity increments in hydrodynamic turbulence, distribution of financial drawdowns, distribution of the energies of epileptic seizures in humans and in model animals, distribution of the earthquake energies). We emphasize the importance of understanding dragon-kings as being often associated with a neighborhood of what can be called equivalently a phase transition, a bifurcation, a catastrophe (in the sense of René Thom), or a tipping point. The presence of a phase transition is crucial to learn how to diagnose in advance the symptoms associated with a coming dragon-king. Several examples of predictions using the derived log-periodic power law method are discussed, including material failure predictions and the forecasts of the end of financial bubbles.

About Miguel Barbosa

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04. August 2009 by Miguel Barbosa
Categories: Curated Readings, Risk & Uncertainty | Leave a comment

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