What Is Tail Risk? Definition and Tail Risk Hedging

    Tail risk arises due to uncertain and unforeseen economic events. These events can make certain asset prices fluctuate considerably. Certain economic shocks can affect the return on investment for a particular asset class or economic growth. These unforeseen events create extreme volatility and can have a detrimental effect on your investments. Although events linked with this risk cannot be predicted, certain methods can help investors hedge against it.

    What is a tail risk?

    Tail risk is the risk of extreme downside performance of an asset. It happens when an investment’s downside performance exceeds expected risks for prolonged duration, frequency, and magnitude that an investor would plan normally.

    Tail risks are often related to economic shocks and sudden events. These unprecedented, unpredictable, and sudden events are often labeled as “black swans”. The term was coined by Nassim Taleb, whose book “Black Swan: The Impact of the Highly Improbable” has become one of the most acclaimed books on risk.

    These events can send shock waves across the industry or a particular class asset. These events cause excessive capital flow from one asset class to another. Investors’ asymmetric demand derives the consistent and large capital flows within the equity or other asset classes. Under normal circumstances, the investors’ demand-supply curve would remain in equilibrium. The volatility caused by tail risk can widen the bid-ask spread

    Since tail risk often derives from unpredictable situations, investors have a hard time calculating and hedging against these events. Investors are able to predict the downside risks of an investment with a certain degree of certainty. However, when it comes to tail risk it is much more challenging to quantify. Making it difficult to hedge against tail risk. However, there are a few ways that investors and traders can hedge their tail risk.

    Under extreme economic shocks, investors would move their investments from one asset class to another consistently. The shift creates large capital flow waves. For example, the investors may shift capital investments from equity to bonds.

    The shift further escalates the tail risks that prolong the duration and magnitude of losses for investors. The phenomenon can be observed within the same asset class, within the market, or in an economy.

    Normal distribution

    According to the normal distribution theory, the average return on an investment will be in equilibrium within three standard deviations from the average normal distribution.

    It assumes that around 99.7% of the investments show the same magnitude of deviation for investment risks. It means there is only a 0.3% chance of an extreme or unlikely economic shock.

    The historic evidence suggests that there have been several shock waves or economic events that resulted in fatter tails of investment returns. The standard deviation of more than three could be observed across several investment types and asset classes including the high-performing S&P 500 index as well.

    By definition, tail risks are unforeseen. These events are uncertain and cannot be predicted accurately. However, analysts offer insights and forecasts that can help in the prediction of these events. 

    Tail risk hedging

    If the tail risk arises due to unforeseen events, does it mean you cannot hedge against the tail risk?

    There are a few ways that you can use to mitigate these risks. However, many investors underestimate the magnitude and frequency of the tail risks driven events.

    Hold and time-out

    The easier way is to sit-out things. It means to wait until the market ratifies. This approach is less costly in terms of arrangement costs. However, it means you cannot ensure that you’ll recoup the losses incurred during the periods of tail risks. Also, not all investors can afford to hold for such long periods.

    Hedging tail risk

    Hedging against the tail risk can be expensive but it mitigates the risk. Investors can arrange customized swaps or purchase puts. The arrangements work as an insurance cover for investors that essentially transfers the risks from investors to counterparties willing to accept the risks.

    However, like any other sophisticated insurance cover, hedging against the tail risk does not come cheaply. Also, these arrangements are complex and require special arrangements that most investors would not be able to afford.

    Hedging tail risk is also challenging because a particular event might influence asset prices in a very specific way. Therefore it becomes difficult to predict how asset prices will react to an unforeseen event.

    Diversification

    Considering the costs, complexity, and other factors, the diversification option is the most suitable method to mitigate the tail risk.

    Multi-Asset diversification further reduces the tail risks for investors. It means broadening the investment portfolio across several asset classes. Remember, the concept of tail risks arises due to capital flow from one asset class to another.

    The multi-asset diversification with investments in assets generates different returns. The approach naturally aligns with the broader factors that cause the tail risks in the first place. Allowing investors with a multi-asset portfolio to perform better during black swan events.

    Tail risk hedging strategies

    There are two easy tail risk hedging strategies to employ that tend to be the best solution for investors. One of them is to short high-yield corporate bonds. These bonds tend to have stable prices, however, an unforeseen event could lead them to trade at lower levels. 

    The cost of shorting these bonds is relatively cheap, and therefore it hedges investors’ portfolios against any of these situations.

    Another common hedging strategy that may take some time to materialize is to select negative beta securities. On average, the price of these securities tends to rise when the market dips. Making it one of the simplest solutions to hedge against tail risk. Diversifying your portfolio with negative beta securities can be a simple yet effective way of mitigating tail risk.

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