A Peer-based Model of Fat-tailed Outcomes

TL;DR

This paper proposes a micro-level model explaining fat-tailed return distributions in finance by incorporating agents' private valuations and social influence in their utility functions.

Contribution

It introduces a novel agent-based model where private valuations are normally distributed but social factors induce fat-tailed outcome distributions.

Findings

The model reproduces leptokurtic return distributions observed in financial markets.

Social influence among agents leads to skewed and fat-tailed outcomes.

The approach provides a microeconomic foundation for fat-tailed financial returns.

Abstract

It is well known that the distribution of returns from various financial instruments are leptokurtic, meaning that the distributions have "fatter tails" than a Normal distribution, and have skew toward zero. This paper presents a graceful micro-level explanation for such fat-tailed outcomes, using agents whose private valuations have Normally-distributed errors, but whose utility function includes a term for the percentage of others who also buy.