Following the 2008 Financial Crisis, conventional financial theories have been challenged for their inability to realistically explain risk. Traditional strategies of asset pricing often rely on a normal bell curve to make market assumptions, but in reality, the markets don't behave this way. Under a normal distribution, a majority of asset variation fall within 3 standard deviations of its mean which subsequently understates risk and volatility.
Unfortunately, history would suggest financial markets don't always act this way and rather, they exhibit fatter tails than traditionally predicted. By definition, fat tails are a statistical phenomenon exhibiting large leptokurtosis. This represents a greater likelihood of extreme events occurring similar to the financial crisis. Since the magnitude of fat tails are so difficult to predict, left tail events can have devastating effects on portfolio returns. As a result, sufficiently protecting a portfolio requires tail risk hedging from unexpected market events.
In order to understand the significance of tail risks, it's important to understand the notion of a normal distribution and its shortcomings. A normal distribution assumes that, given enough observations, all values in the sample will be distributed equally above and below the mean. About 99.7% of all variations falls within three standard deviations of the mean and therefore there is only a 0.3% chance of an extreme event occurring. This property is important because many financial models such as Modern Portfolio Theory, Efficient Markets and the Black-Scholes option pricing model all assume normality. However, the marketplace is less than perfect and largely influenced by unpredictable human behavior, which leaves us with fat tail risks.
The aftermath of the 2008 Financial Crisis highlighted the shortcomings of conventional financial wisdom. Even when everything is well crafted or normal, unexpected events can still pose a threat. These potentially catastrophic events highlight the ongoing relevance of fat tails throughout the finance industry.
By definition, a fat tail is a probability distribution which predicts movements of three or more standard deviations more frequently than a normal distribution. Even before the financial crisis, periods of financial stress had resulted in market conditions represented by fatter tails. This is important because normal distributions understate asset prices, stock returns and subsequent risk management strategies.
The 2008 Financial Crisis has been caused by a series of events including subprime loans, credit default swaps and large leverage ratios. As a result, major companies went under (Bear Sterns, Lehman Brothers), markets crashed and the foundation of the global economic system was undermined. Prior to this, financial institutions had appeared to be operating without any downside due to the shortcomings of normally distributed models. Since 99.7% of variances fall within three standard deviations of its mean, the notion of visible profits and invisible losses created a highly risky financial environment. Moving forward, models must focus on how the behavior of assets relates and contributes to fat tails in order to adequately manage tail risk.
Tail Risk Hedging
Being aware of extreme events associated with fat tails is not enough to protect an investment from economic turmoil. The ideal portfolio will not only generate a good return for each unit of volatility, but will also provide some assurance against tail risk. Engaging in tail risk hedging requires an active preference for avoiding downside risk at the expense of higher returns. A few methods to limit tail risks include liability hedging and diversification.
Diversification is the most important concept in investing and encompasses holding multiple different asset classes which are uncorrelated. Popular assets to diversify from tail risk include derivatives and specifically the CBOE Volatility Index, which can be leveraged in order to scale exposure to risk. Of course, this strategy presents its own concerns since it can be difficult to close out derivatives positions in certain market conditions.
Not surprisingly, declines in the equity market negatively impacts the status of pension plans. At its core liability hedging uses assets, particularly derivatives, to compensate for changes in liabilities. During tail events, liability hedging can be used to reduce exposure to changes in interest rates, inflation, and equity volatility. In particular, interest rate swaptions have become an attractive tool as a liability tail risk hedge when interest rates decline. Hedging strategies can often have some short term costs, but over time they are designed to mitigate losses and provide liquidity during crises.
In the post crisis era, it is becoming accepted that financial asset returns exhibit fatter tails than normal distributions. Since normally distributed models still resonate throughout the finance industry, the downside risk of a portfolio still remains understated. Simply being aware of fat tails is not enough protection against extreme financial turmoil. Complementing a portfolio with tail risk hedging, while costly in the short term, can have long term benefits during crises.