The Rush to Hedge Against Black Swan Events
Wall Street is seeing a boom in funds that offer protection from market calamities known as "long-tail risks"
- Shannon Harrington, Miles Weiss and Sree Vidya Bhaktavatsalam for businessweek.com July 22nd, 2010
- Source: http://www.businessweek.com/magazine/content/10_31/b4189043850912.htm
Wall Street's hottest new product is fear. Pimco, Deutsche Bank (DB), and Citigroup (C) are among firms offering clients protection against "long-tail" risks-extreme market moves that Wall Street's financial models fail to anticipate. In what Morgan Stanley strategists say is an indication that more investors are seeking insurance against financial turbulence, they estimate there was as much as a fivefold increase last quarter in trading of credit derivatives that speculate on market volatility.
The term long-tail risk is derived from the outlying points on bell-shaped curves that forecasters use to plot the probability of losses or gains in a given market. The most probable outcomes lie at the center. The least probable, such as a decline of 5 percent in an index that most days rises or falls by less than 0.25 percent, are plotted at the "tail," or the end of the curve. The greater the deviation, the longer the tail.
Before the 2008 financial crisis, author Nassim Nicholas Taleb [of Polytechnic Institute of NYU] warned bankers that they relied too much on probability models and had become blind to potential cataclysms, which he labeled black swans. That's a reference to the widely held belief that only white swans existed-that is, until black ones were discovered in Australia in 1697. His 2007 book, The Black Swan, contends tail risks are becoming more severe.