Definition
Tail risk refers to the probability and magnitude of extreme outcomes that occur more frequently than normal distribution models predict. Financial returns exhibit "fat tails"—extreme events like the 2008 crisis or March 2020 crash occur far more often than bell-curve statistics suggest. Tail risk hedging strategies include put options, volatility exposure, and managed futures.
lightbulb Example
A normal distribution predicts a 3-sigma daily loss (>3 standard deviations) should occur once every 7 years. In reality, the S&P 500 has experienced 3-sigma daily losses multiple times per decade, demonstrating fat tails.
verified_user Key Points
- Extreme events occur more often than normal distribution predicts
- Fat tails characterize financial return distributions
- 2008, 2020 were tail risk events
- Hedging strategies: puts, VIX calls, managed futures