Definition Tail Risk

As a result, active management minimizes “negative carry” (a state in which the cost of holding an investment or security exceeds the income earned during holding)[9] and provides sufficient ongoing security and a truly convex payment delivered in tail events. In addition, it is possible to reduce counterparty risk, which is particularly relevant for extreme events. The recent global financial crisis, which had a significant impact on investment portfolios, has led to a significant awareness of tail risks. Even highly developed institutions such as U.S. academic foundations, long-established sovereign wealth funds, and highly experienced public pension plans suffered large double-digit percentage impairment losses during the global financial crisis. According to McRandal and Rozanov (2012), the losses of many broadly diversified multi-asset class portfolios ranged from 20% to 30% in a matter of months. [6] The example of the Dow Index best explains the tail risk event and how it can affect the market as a whole. If you want to implement an effective extreme risk hedging program, you must first carefully define the tail risk, that is, identify the elements of an extreme event that investors hedge against. A true tail event should have the following three characteristics simultaneously with significant size and speed: falling asset prices, rising risk premiums, and increasing correlations between asset classes. [6] Stock market returns tend to follow a normal distribution with excessive kurtose.

Kurtosis is a statistical measure that indicates whether the observed data follow a heavy or light tail distribution compared to the normal distribution. The normal distribution curve has a kurtose equal to three, and if a safety follows a distribution with a kurtose greater than three, then it is said to have fat tails. An extreme risk can be better understood by taking a concrete example. In 2007, the health of 30 publicly traded companies from the United States of America was included in the Dow Index, these companies were also part of the S&P 500 Index. The index posted an excellent performance, surpassing the 24k mark in December 2017 and has shown an upward movement since then. Although tail events that have a negative impact on portfolios are rare, they can have significant negative returns. Therefore, investors should hedge against these events. Hedging against tail risk is intended to boost long-term returns, but investors have to bear short-term costs. Investors can try to diversify their portfolios to hedge against tail risks.

While it`s rare for tail events to have a negative impact on portfolios, they can have big negative returns. Therefore, it is important that investors hedge against rail events. Keep in mind that investors hedge against tail risks so that they can increase returns over the long term. In this case, the diversity of portfolios is important for investors when they need to hedge against tail risks. Extreme risk occurs when it is possible for three standard deviations to deviate from the mean. As a general rule, financial markets assume that the returns generated by securities and portfolios have a normal distribution. Such a distribution is also called bell-shaped distribution. But the tail risk suggests that these payments are not normal but have larger tails, the left side of the tail represents the lowest return an investor can get on the investment, while the right side of the tail represents the highest return an investor can get. It can also be called left tail risk and right tail risk, depending on the sides; Left tail risk shows negative returns, while right tail risk has positive portfolio returns. Tail risk allows investors and companies to assess the risk of the investment they are making. If tail risk had been analyzed for the business activities in which it moved, the company could have been better managed to avoid the great collapse of 2007-08 that shook the world. Note that there are two options that investors can use to hedge against tail risk.

They are as follows: The tail risk is highlighted in Nassim Taleb`s best-selling financial book, The Black Swan. The left end of the green curve indicates the amount of loss an investor can incur, while the far right of the green curve indicates how much the investor can earn on investments. One good thing about using this approach is that it is flexible and cost-effective compared to strategy options. Another advantage is that its protection is immediate, especially in case of events such as 9/11. Keep in mind that to get adequate returns, investors need to take more risk. This means that they must disclose their risky assets as follows: In general, tail risk management is a rare situation, which means that the probability of this happening is very low. However, that doesn`t mean it can`t happen. Therefore, it is important for investors to ensure that they hedge against this risk. However, these statistical characteristics can only be validated retrospectively, so hedging against these events is a rather difficult, albeit important, task to ensure the stability of a portfolio whose objective is to achieve its long-term risk-return objectives.

Tail risk is a form of portfolio risk that arises when the possibility of an investment moving more than three standard deviations from the average is greater than what shows a normal distribution. Overall, tail risk is an event with a low probability of it occurring, says Bob Conroy, a professor of finance at the Darden School of Business at the University of Virginia. “In any case, there are tails; There are really, really good things that can happen, and really, really bad things. Tail risk refers to a form of portfolio risk where it is possible for an investment to move beyond three standard deviations from its prevailing price. Tail risk measures the spread between investment returns and average returns. The probability of occurrence of tail risks is generally low and occurs at both ends of the normal distribution curve of the bell curve. The diagram below shows three curves of increasing straight inclination with bold tails downwards – and which are different from the symmetrical shape of the bell curve of the normal distribution. While tail risk cannot be eliminated, its effects can be somewhat mitigated by robust diversification across assets, strategies and the use of asymmetric hedging. The following graph shows the normal distribution (in green) as well as increasingly leptocurtic curves (in red and blue), which have fat tails. Extreme risk is very difficult to measure because tail events occur rarely and with different effects. The most popular measures of extreme risk include conditional value at risk (CVaR) and value at risk (VaR). These measures are used both in the finance and insurance sectors, which tend to be highly volatile, and in highly reliable and safety-critical hazardous environments with highly diluted underlying probability distributions.

[7] For an investor, it is essential to apply diversified risk management to ensure effective and additional protection.