There is a current strong focus on tail risk by many investors, yet by definition, tail risks are extremely hard to measure or even describe. The presidential election, pandemic changes, geopolitics, and general policy changes are all the focus of investors as tail risks, yet to be useful these topics have to be quantified and placed in form that is measurable. By definition, there have been few shock events that have driven markets to the tail of the distribution. Hence, there is only a small sample. The frequency distribution is limited, so there is a clear focus on subjective expectations of magnitude and likelihood.
There has to be a "tale" that creates or describes the subjective expectations for the tail event. There can be a simple process that can be used as a framework for any tail risk discussion. This is the risk assessment and scenario building of whether a tail risk may happen. This assessment analysis is a separate process from what action should be taken.
The first question is whether the tail event contemplated has ever been experienced before. If it has been seen in the market, then extreme value theory can be applied with perhaps adjustments for the current unique situation. Extreme value theory can also be used as a prior to calibrate any tail analysis.
The alternative from using a prior similar event will be to formulate a subjective narrative for a unique tail situation. This requires a story of what will happen, when it will happen, and the likelihood of the event. Of course, a tail event cannot be looked at in isolation. A shock to US equity markets will have an impact on bonds and credit, as well as spill-over to the rest of the world. Additionally, the policy response has to be modeled as a second order effect. Hence, there is a tale with a tail event.
After the tail event tale is developed, a hedge or action plan can be developed. Of course, an action plan can also be developed for a tail event that is not imagined yet expected.
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