Beauty Contests and Fat Tails in Financial Markets

34 Pages Posted: 4 Dec 2013 Last revised: 3 Aug 2015

See all articles by Makoto Nirei

Makoto Nirei

University of Tokyo

Koichiro Takaoka

Hitotsubashi University

Tsutomu Watanabe

University of Tokyo - Graduate School of Economics; Tokyo Center for Economic Research (TCER)

Date Written: August 3, 2015


This study seeks to explain the emergence of fat-tailed distributions of trading volumes and asset returns in financial markets. We use a rational expectations form of the herding model. In the model, traders infer other traders' private signals regarding the value of an asset by observing their aggregate buying actions. The rational expectations equilibrium outcome entails an upward sloping demand curve. This is because the information contained in others' signals is more encouraging than is reflected in the incremental price. That is, there are strategic complementarities in informed traders' buying actions. In this environment, we show that equilibrium trading volumes and asset returns follow fat-tailed distributions without making any parametric assumptions on private signals. Specifically, we demonstrate that the trading volume follows a power-law distribution when the number of traders is large and the signal is noisy. Furthermore, we provide simulation results to show that our model successfully reproduces the observed distributions of daily stock returns.

Keywords: Herd behavior; trading volume; stock return; fat tail; power law

JEL Classification: G14

Suggested Citation

Nirei, Makoto and Takaoka, Koichiro and Watanabe, Tsutomu and Watanabe, Tsutomu, Beauty Contests and Fat Tails in Financial Markets (August 3, 2015). Available at SSRN: or

Makoto Nirei (Contact Author)

University of Tokyo ( email )

7-3-1 Hongo
Tokyo, 113-0033

Koichiro Takaoka

Hitotsubashi University

2-1 Naka Kunitachi-shi
Tokyo 186-8601

Tsutomu Watanabe

Tokyo Center for Economic Research (TCER) ( email )

Sankyo Building
Room 703, Main Building
Chiyoda-ku, Tokyo, 1-7-10

University of Tokyo - Graduate School of Economics ( email )


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