Tail Risk Definition
Tail Risk is defined as the risk of occurrence of an event that has very low probability and is calculated as three times the standard deviation from the average normal distribution return. Standard deviation measures the volatility of an instrument with relation to the return on investment from its average return. Investors look at tail risk to assess and invest in different hedging positions to mitigate the loss that could arise out of possible tail risk. Strategies adopted by investors to curb the losses arising out of tail risks actually have the potential to add value at the time of crisis. Tail risk not just refers to the movement of an instrument but may also refer to any investment or business activity whose growth or downfall can be monitored.
The possibility of tail risk to take effect is minimal however; if it happens the magnitude is high which would hit related portfolios as well. It can cause huge implications in the financial markets and the economy. It may occur at either end of a distribution curve.
Examples of Tail Risk
The following are examples of tail risk
Example #1
Dow Jones Industrial Average or Dow Index shows the health of 30 public companies based out of the United States of America. The companies in the Dow Index are also a part of the S&P 500 Index. The Index was performing well from the inception and went above the 24k mark in Dec 2017. Since then it had an upward movement and the market attracted more and more investors.
In Jan 2018, the Index hit the 26k mark and investors were expecting the market to boom further but due to economic slowdown and trade wars, the whole of the US equity market plunged thereby resulting into the fall of Dow Index as well. The Index went through several ups and downs and reached back to the 24k mark in Oct 2018 which was the lowest mark it hit in over a year. This was a 10% move and had a concerning effect on the market.
The market went on to lose another 6% in Dec 2018 and affected volatility across the market. This was a huge fall for the market. In Dec 2018, the index plunged to 21k which was over 19% downward move from the high in that particular year. This was a major fall for the Index and had an impact in the days to come on the market.
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Source – Finance.yahoo.com
The tail risk in the case of the Dow Index was when the market started taking a downward move in Oct 2018. The fall at that period was to 24k which was just a behavioral movement however the conditions got worse when the index started going below the 24k mark.
The example of the Dow Index best explains the tail risk event and how it can affect the market as a whole.
Example #2
The case of Lehman Brothers is well known to the world due to its notorious effect on the banking industry. Lehman was considered ‘Too Big to Fail’ owing to its large market capital and revered client base across the globe. Due to lenient policies and incorrect reporting, the business could not hold up to the changing market. The same was the case with Bear Stearns.
The aftermath of the Lehman collapse was so severe that it had impacted all other industries including steel, construction, and hospitality to name a few. The tail risk in Lehman’s case had impacted not just the banking industry but trickled down to other industries as well, resulting in major setbacks and economic losses that affected the GDPs of many countries. The impact on the economy was so grave that it leads to recession across the globe. The incident resulted in an economic slowdown and many people being unemployed due to the layoffs across all industries.
There were numerous reports on how the business was not being run right and how it would result in a major collapse. However, none of the reports were given weight until the problem had reached a mammoth stage when it was unstoppable.
Before Lehman filed for bankruptcy, the business activities it was heading into had to be monitored and correct reporting of all its economic conditions had to be made which lead to a major mishap.
Tail risk enables not just investors but also businesses to gauge the risk involved in the investment they make. If the tail risk had been analyzed for the business activities it was heading into the business could have been lead in a better way to avert the great collapse of 2007-08 which shook the world.
Advantages
- Tail risk allows investors to gauge the risk involved in the investment and enhances decision making in hedging strategies.
- Tail risk encourages hedging which results in increased inflow of funds into the market.
- Creates awareness about any possible negative movement which can disrupt the market.
Disadvantages
- An investor may be encouraged to overly invest in hedging strategies on the basis of the tail risk.
- There is a high possibility for a tail risk event to not occur even once.
- Creates a sense of fear among investors thereby resulting in a negative outlook.
Important Points
- The left end of the curve indicates the extreme downside.
- Tail risk depicts an event that may occur if the market makes an unfavorable move.
Conclusion
- Tail risk is the possibility of a loss that might occur as per a prediction of probability distribution due to a rare event.
- A short term movement of three times the standard deviation is considered to represent a tail risk.
- Tail risk can be on both sides of the curve, right indicates profits whereas left indicates losses. Since it is a risk, the focus is more on the left side of the curve.
- Tail risk encourages hedging strategies since hedging reduces potential loss.
- Investors and businesses alike can study tail risk to understand the risk involved in an investment.
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