Black Swans and Tail Risk

August 27, 2010

Black swan events and tail risk are key phrases in financial and risk management today. They specifically describe very unlikely or unusual events, or, in statistics, an increased probability that the outcome will be more than three standard deviations from the mean. Tail risk refers to fatter “tails” than a normal bell curve distribution in statistics. A “black swan” event has a small probability of occurring, but when it does, it has large implications.

Since the first of the year, two black swan events have occurred. The first is increased price of wheat because of the Russian drought and unusual weather in other wheat producing areas of the world. The other evening at a young farmer event in Perrysburg, Ohio, Chuck Beier of The Anderson’s, Inc. spoke on the market outlook. The long and short of it was that wheat prices increased $2.51 per bushel in 27 days this summer. The black swan that exposed the Russian wheat crop boosted prices to producers in this country despite reasonable levels of inventory. Many producers who locked in a price for their entire crop have left money on the table. The point is that a diversified strategy of risk management is imperative.

A second tail risk occurred earlier this spring with the debt crisis in Greece. Greece’s total debt to GDP is 124 percent. This created havoc in world money markets when there were questions of whether debt service obligations could be met. Rates on debt obligations rose nearly three times in a matter of 60 days, as funds managers were seeking premiums for risk on Greek debt.

While rates are low in this country despite our large amounts of federal debt, at 92 percent of GDP, could a black swan event occur in the United States?

How does one prepare for black swans and tail risk?

• Keep a large amount of cash and assets that can quickly be turned to cash without disrupting normal business operations.
• Maintain a modest amount of debt that is well structured.
• Develop a three-prong risk management program, involving revenue, cost, and interest rates, which is diversified and does not put “all your eggs in one basket.”