What is Kurtosis?
Kurtosis is a quantitative indicator that defines the extent to which outcomes are clustered in a frequency distribution’s tails or peak. The peak of the distribution is the highest point, while the tails are the lowest points. It is concerned with the distribution’s tails, not with its peak or flatness. It is, in essence, a measurement of the number of outliers in the distribution.
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Overview:
Kurtosis is derived from the Greek word “kyrtos or kurtos” which means curved, arching. It describes the shape of a probability distribution. It measures the degree of tailedness of a distribution. It is a measure of the combined weight of a distribution’s tail in relation to the center of a distribution. The average of standardized data raised to the fourth power is kurtosis. Statistically, it is useful in describing the distribution of data sets and shows up to what extent the data sets differ from data of normal distribution.
Types of Kurtosis:
There are 3 types of kurtosis: –
- Mesokurtic: In kurtosis, if a data set falls close to zero or equal to zero, it is known as Mesokurtic. A Mesokurtic curve represents moderate risk levels. It means a data set follows the normal distribution.
- Leptokurtic: When kurtosis is positive i.e. more than zero, it is known as leptokurtic. This distribution shows that investment returns may have high volatility on a huge scale. The investments in this distribution are very risky. It has heavy steep curves on both sides indicating a heavy population of outliners.
- Platykurtic: If the kurtosis is less than zero or negative, it is known as platykurtic. It has pale or subtle curves indicating a small population of outliners. The investments in this distribution are less risky and are considered safe investments.
Uses in the financial market:
- Kurtosis is a very useful measure of financial risks. It has practical applications, particularly in the field of economics, rather than being a theoretical concept.
- A large kurtosis refers to the high level of risks for an investment as the probability of returns may be extremely large or extremely small. A small kurtosis refers to moderate levels of risks as the probability of extreme returns is very low.
- Since ignoring the tail risk can lead, to an alphas overvaluation, kurtosis should therefore become part of the overall financial security performance assessment. Kurtosis is an extremely useful way of measuring the tail-risk in financial instruments.
- When it is used in combination with Algorithmic Trading, it may dramatically boost the trading returns.
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Key Takeaways:
Kurtosis helps measure the risk of an investment. A Mesokurtic investment has moderate risk, a leptokurtic investment has high risk and a platykurtic investment has very low risk. Investors consider it as a crucial factor for determining the risk of a portfolio.
Author: Urvi Surti
About the Author:
Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).
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