Tail Risk

As Darren Winters points out, keeping an eye on tail risk in the age of frothy asset prices fueled by unprecedented central bank liquidity and the recent black swan event (or maybe better said black bat event) Coronavirus would be prudent. 

“Anyone pricing assets must consider the ‘tail risk’ that virus outbreak could ‘get much worse’ until it is contained,” said St. Louis Fed President James Bullard who participates on Federal Open Market Committee (FOMC), which is responsible for deciding monetary policy. 

But what is a tail risk?

Tail risk is sometimes defined less formally, as merely the risk (or probability) of rare events

Keeping an eye on tail risk

Darren Winters explains that tail risk is more formally defined as the additional risk of an asset or portfolio of assets moving more than 3 standard deviations from its current price, above the risk of a normal distribution. 

In statistics, the standard deviation is a measure of the amount of variation or dispersion of a set of values. A low standard deviation indicates that the values tend to be close to the mean (also called the expected value). 

A tail-end risk can wreak havoc on portfolio values, so it is wise to have it weighed into your investment decision. 

But what index measures the perceived tail end risk?

The Skew Index measures perceived tail-risk in the S&P 500.

The SKEW INDEX measures potential risk in financial markets much like the VIX index measuring the market sentiment of fear versus greed. 

If the Skew Index measures tail risk, we need to understand the Skew Index

The SKEW index is calculated using S&P 500 options that measure tail risk — returns two or more standard deviations from the mean — in S&P 500 returns over the next 30 days. 

SKEW values generally range from 100 to 150 where the higher the rating, the higher the perceived tail risk and the likelihood of black swan events occurring.

A SKEW rating of 100 means the perceived distribution of S&P 500 returns is normal and, therefore, the probability of an outlier return is small. 

The SKEW index increases market awareness of a tail risk black swan event occurring

As the slope of implied volatility moves higher, it raises the SKEW Index, which indicates that a Black Swan event is becoming more likely but not that it will occur. 

The only measurement of tail risk, the Skew Index has had a poor track record of predicting stock volatility

Darren Winters looks back over three decades, going back to 1990 not one of the worst stock declines over that period had a SKEW Index in the prior month that was within the top 5% of historical values. Put another way when actual tail risk was present, SKEW was unable to predict it. 

Pricing tail risk into your portfolio is particularly relevant today, bearing in mind that the coronavirus spread and kill rate is growing exponentially

GSMA cancels the mobile world conference in Barcelona due to the coronavirus. The coronavirus is a tail end risk that has become a reality. Already it has triggered a number of  force majeure for commodity deals. 

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