Branching epistemic uncertainty and thickness of tails
share
This is an epistemological approach to errors in both inference and risk management, leading to necessary structural properties for the probability distribution. Many mechanisms have been used to show the emergence of fat tails. Here we follow an alternative route, the epistemological one, using counterfactual analysis, and show how nested uncertainty, that is, errors on the error in estimation of parameters, lead to fattailedness of the distribution. The results have relevant implications for forecasting, dealing with model risk and generally all statistical analyses. The more interesting results are as follows: + The forecasting paradox: The future is fatter tailed than the past. Further, out of sample results should be fatter tailed than in-sample ones. + Errors on errors can be explosive or implosive with different consequences. Infinite recursions can be easily dealt with, pending on the structure of the errors. We also present a method to perform counterfactual analysis without the explosion of branching counterfactuals.
READ FULL TEXT