3 Pages Posted: 13 May 2017
Date Written: May 12, 2017
Uncertainty affects all aspects of economics. A principle this vital demands a mathematically precise definition. The distinction between risk and uncertainty, as made by Frank Knight (1921) and John Maynard Keynes (1937), invites the following definition (Anderson, Ghysels & Juergens 2009): An event is risky if its outcome is unknown but the distribution of its outcomes is known. By contrast, an event is uncertain if its outcome is unknown and the distribution of its outcomes is also unknown. In fat-tailed problems where historical evidence does not reflect the true distribution of extreme outcomes, kurtosis approximates uncertainty. This intuition arises from options pricing models where both price and volatility fluctuate stochastically (Heston 1993).
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