Empirical Distributions of Stock Returns : Between the Stretched Exponential and the Power Law?

A large consensus now seems to take for granted that the distributions of empirical returns of financial time series are regularly varying, with a tail exponent b close to 3. We develop a battery of new non-parametric and parametric tests to characterize the distributions of empirical returns of moderately large financial time series, with application to 100 years of daily returns of the Dow Jones Industrial Average, to 1 year of 5-min returns of the Nasdaq Composite index and to 17 years of 1-min returns of the Standard & Poor's 500. We propose a parametric representation of the tail of the distributions of returns encompassing both a regularly varying distribution in one limit of the parameters and rapidly varying distributions of the class of the stretched-exponential (SE) and the log-Weibull or Stretched Log-Exponential (SLE) distributions in other limits. Using the method of nested hypothesis testing (Wilks' theorem), we conclude that both the SE distributions and Pareto distributions provide reliable descriptions of the data but are hardly distinguishable for sufficiently high thresholds. Based on the discovery that the SE distribution tends to the Pareto distribution in a certain limit, we demonstrate that Wilks' test of nested hypothesis still works for the non-exactly nested comparison between the SE and Pareto distributions. The SE distribution is found to be significantly better over the whole quantile range but becomes unnecessary beyond the 95% quantiles compared with the Pareto law. Similar conclusions hold for the log-Weibull model with respect to the Pareto distribution, with a noticeable exception concerning the very-high-frequency data. Summing up all the evidence provided by our tests, it seems that the tails ultimately decay slower than any SE but probably faster than power laws with reasonable exponents. Thus, from a practical viewpoint, the log-Weibull model, which provides a smooth interpolation between SE and PD, can be considered as an appropriate approximation of the sample distributions.