Fat-tailed price distributions were documented decades before the 1987 crash

Evidence

That the distributions of price changes over short time periods had fat tails (high frequencies of extreme events) was known before 1987: Mandelbrot and Fama had made the point vigorously in the 1960s. Furthermore, as discussed in chapter 7, there is a sense in which the options market has “over-learned”: the magnitude of the skew is greater than can be accounted for simply by the extent to which the empirical distributions of price changes have fatter tails than the log-normal model underpinning Black-Scholes-Merton. — Donald MacKenzie, An Engine, Not a Camera, 1163

Categorization

• DEEPTHINKING: The ‘over-learned’ skew — markets pricing in more tail risk than the actual distributions warrant — is a subtle, dense point about socially-anchored model calibration that rewards extended reflection.
• QUESTION: Why would markets over-correct beyond what fat tails justify? This invites investigating the social/psychological dynamics of post-crisis pricing.
• XREF: connects to: The 1987 crash permanently shifted the S&P options market’s implied distribution toward crash expectations. — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 143; The October 1987 crash ended the flat volatility curve predicted by Black-Scholes — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 900; The 1987 crash was a multi-sigma event under the log-normal assumption. — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 142 (+1 more)