Glossary term
Tail Risk
Subject: Risk Management, Risk Assessment and Quantification
Also known as: Extreme risk, Fat-tail risk
Tail risk is the chance of rare, extreme outcomes that sit at the far ends of a probability distribution and can cause losses much larger than usual.
Explanation
Picture a bell-shaped curve of possible results. Most outcomes cluster around the middle, and the extremes lie in the thin tails. In real markets and operations, the tails are often fatter than a normal curve suggests, so severe events happen more often than simple models predict. Examples include a market crash, a major cyber attack, a pandemic or the failure of a large counterparty. Averages and standard deviations tell little about these events. Tools aimed at the tail include expected shortfall, stress tests, scenario analysis and extreme value statistics. Managers respond by diversifying, limiting concentrations, buying insurance, holding extra capital and planning for continuity. Tail events are rare, so there is little data, and expert opinion fills the gap. One tail event can erase years of ordinary profit, which is why averages alone are a poor guide.
Example
An investment fund earns steady small gains from selling insurance against market falls. Models show little risk because losses are rare. In a sudden crash, the fund pays out heavily and loses several years of profit in a week. A later review blames the models for ignoring the tail.
Not to be confused with
- Systemic Risk
- Systemic risk is the danger of failure spreading through a financial system. Tail risk is any rare, extreme outcome, whether or not it spreads.