Tail risk now - Are the markets telling us something?

I actually saw a Black Swan. It was in Zurich and I wish I had a camera to capture that odd moment. Tail risks, by definition, are rare but they do occur. Their occurrence is often more frequent than what we generally think often because we try and force market behavior into a normal distribution. We live in a fat tail world.

However, the changing expectations of fringe or rare events will have a significant impact on extremes in the distribution. A small change in probabilities may have a big impact on the pricing of out of the money options. Small changes in extreme views will have a big impact on extreme expectations.

Have the potential for black swans been noticed or priced in financial markets? If you look at volatility the answer is yes. A simple example is the volatility with the euro. Three month ATM volatility has increased 80 percent in the last year. The spread of possible prices has widened so a two standard deviation event will be significantly further from the mean. Any "tail event" is going to have a bigger market impact. A two standard deviation event in a high volatility state will have a greater price impact than a bigger deviation in a low vol stat. It is the tale of volatility.

While volatility has increased, we have not seen significant increases in  stress indicators. They have increased but do not indicate a concern at this time. We also have not seen increases in uncertainty indicators. Market prices variability has been increasing but fundamental tail signals have been more mixed.  The Citibank surprise index has fallen quickly but is not at recession levels; nevertheless, this should be a growing concern. The trend is down.

The question is whether markets are ready for a tail event. If volatility is higher then the price impact of any two standard deviation event should be reflected in prices. However, most investors still focus on the mean and not the whole distribution so it is unclear whether investors are ready for an event. If you are not tracking the entire distribution, you better get ready for some tail risk.