Tail Risk
The risk of rare, extreme outcomes that sit far in the tails of the return distribution.
How it is identified
Test: outcomes beyond three standard deviations occur far more often than a normal distribution would imply
Unit
qualitative
In depth
Financial returns have fatter tails than the normal distribution, so events that the standard model says should occur once in a century occur every decade or two — this is a well-documented empirical fact, not a theoretical quibble. It matters because most risk measures, including value at risk and the Sharpe ratio, are built on the normal assumption and therefore systematically understate extreme risk. Strategies that sell tail risk, such as writing far out-of-the-money options, produce smooth returns and excellent ratios right up until the tail arrives. Conditional value at risk and stress testing exist specifically to look where these measures do not.
Worked example
Under a normal distribution, a five-standard-deviation daily move should occur roughly once in seven thousand years. Real equity markets produce several per decade, which is the whole content of the phrase fat tails.
Illustrative figures, chosen so the arithmetic is easy to follow. Not a live price and not a valuation of any company.
Educational reference only
This entry explains what “Tail Risk” means. It is not investment advice and not a recommendation to buy or sell any security. Any numbers above are illustrative, not live prices, and nothing here predicts price direction or rates a stock. Consider your own circumstances and consult a SEBI-registered investment adviser before acting.