Tail Risk Definition Examples Advantages Disadvantages Of Tail Risk

Tail Risk Definition

Tail Risk is defined as the risk of an event that has a 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 concerning the return on investment from its average return. 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. Investors look at tail risk to assess and invest in different hedging positions to mitigate the loss that could arise from possible tail risk. Strategies adopted by investors to curb the losses arising from tail risks can add value during a crisis

The possibility of a tail risk-taking effect is minimal; however, if it happens, the magnitude is high, which would hit related portfolios. It may occur at either end of a distribution curve. It can cause considerable implications for the financial marketsThe Financial MarketsThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more and the economy.

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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 in the United States of America. The companies in the Dow Index are also a part of the S&P 500 Index. The index performed well from its inception and went above the 24k mark in December 2017. Since then, it has had an upward movement, and the market has 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 warsTrade WarsA trade war occurs when one country raises its tariff on imports, and the other country responds by raising its own tariff to restrict imports.read more, the whole of the US equity market plunged, resulting in the fall of the 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 affect volatility across the market. This was a massive fall for the market. In Dec 2018, the index plunged to 21k over a 19% downward move from the high in that particular year. This was a significant fall for the index and impacted the days to come on the market.

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 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 FailToo Big To FailToo Big to Fail (TBTF) is a term used in banking and finance to describe businesses that have a significant economic impact on the global economy and whose failure could result in worldwide financial crises. Because of their crucial role in keeping the financial system balanced, governments step into saving such interconnected institutions in the event of a market or sector collapse. read more 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 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. Still, it trickled down to other industries and resulted in significant setbacks and economic losses that affected the GDPs of many countries. The economic impact was so grave that it led to the global recession. The incident resulted in an economic slowdown and many unemployed people 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 significant 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 led to a significant mishap.

Tail risk enables investors and 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 led 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

Investors may be encouraged to invest overly in hedging strategies based on the tail risk.There is a high possibility for a tail risk event not to occur even once.It creates a sense of fear among investors, resulting in a negative outlook.

Conclusion

Tail risk is the possibility of a loss that might occur as per a prediction of probability distributionProbability DistributionProbability distribution could be defined as the table or equations showing respective probabilities of different possible outcomes of a defined event or scenario. In simple words, its calculation shows the possible outcome of an event with the relative possibility of occurrence or non-occurrence as required.read more prediction due to a rare event.A short-term movement of three times the standard deviation represents 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 can study tail risk to understand the risk involved in an investment.