Is that a fat tail I see?

One side effect of the financial crisis is a much wider familiarity with the wonky lexicon of risk management, which is generally a good thing. But it has its drawbacks. Once a person has learned to spot a black swan, it seems there are black swans everywhere. Of course, the very ubiquity means one isn’t really talking about black swans. Overuse of the term threatens to rob it of its special meaning.

Javier Blass reports in the Financial Times that

One buzzword – “tail risk” – is dominating oil markets and could have big implications for prices for 2012. If this year was marked by relative stability in crude prices, with oil trading in a narrow band between $100 and $120 a barrel in spite of turmoil in the Middle East, next year may be very different. Oil traders and investors are bracing themselves for a rougher ride. In the trading rooms of London, New York and Geneva the talk is of tail risks, low probability events that have an outsize impact on prices. The problem, says Daniel Jaeggi, head of trading at Mercuria, the Geneva-based oil trading house, is that these tails are “currently inordinately fat”. On the one hand are intensifying fears over the eurozone crisis, a bearish factor. On the other, the continuing political turmoil in the Middle East could be bullish. “This means that the [price] outcomes could be substantially altered from the base case if anyone of a number of low probability events materialises,” he says.

So, the probability of prices far above and below the base case is higher than usual. That’s risk alright, but it’s not necessarily a fat tail. It could just be a plain vanilla increase in variance. If the percent change in price is a normally distributed random variable, and the variance goes up, that gives a higher probability of prices far above and below the base case. A fat tail is something more. The normal distribution does not have fat tails, no matter how high the variance.

Maybe the tails are fat. Or maybe it’s just a plain vanilla increase in risk. Not everyone is as punctilious as a pedant on such fine points.

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