Tuesday, July 19, 2011

Tail Risks

We are beginning to field a higher volume of questions than usual from clients who are worried about the debt ceiling debate. And why not? We all remember the conversation leading up to the Lehman Brothers bankruptcy, which went something like, “they can’t be so stupid as to let Lehman go under.” Or perhaps clients remember the 700 point decline in the Dow on the day that the first TARP vote got shot down in Congress. Policy makers are more than capable of making mistakes that can do significant harm to financial markets, and those who are worried about the debt ceiling debate are, at least in my mind, right to be concerned. If lawmakers blow the August 2nd deadline for reaching a deal investors should expect a dizzying amount of short-term volatility in financial markets. For that matter, if the European Union and all of the assorted parties in Europe can’t figure out how to avoid a sovereign debt default by Greece, or Ireland, or Portugal, or whichever country is grabbing the headlines in a given week, we will also see an enormous amount of market volatility…and it won’t be buyers who are leading the charge.  The problem is that the financial markets believe the deal will get made, and so the impact of no deal is not yet priced in.  It's when an unexpected event occurs that markets misbehave.

When investors worry about huge increases in market volatility it is often called “tail risk.” The term refers to the ends of a curve showing a normal probability distribution. Most of us remember bell curves, or Gaussian curves, from some distant college course on probability. The middle of the curve represents the average, and as you move away from the average on each side of the curve the probability of an event occurring decreases exponentially. When you get out to the ends of the curve, where the probabilities are the lowest, that is called the “tail” of the curve. Presumably the probability of a default on U.S. sovereign debt is so low that it would be measured way out in the tails of the probability curve. The problem is that while the probability of these events occurring is very low (well…not in the case of a Greece default which is actually fairly high as currently priced by bond investors), the implication of a U.S. default are drastic. It is a classic case of asymmetric risk. The probability of the event occurring might be as low as 1 in a hundred but if the event does occur it could result in a financial panic.

The question is, of course, what to do about this? The answer begins by realizing that Pinnacle portfolios are diversified and unleveraged. Almost by definition the vast majority of Pinnacle clients would experience a small percentage of equity market volatility in their portfolio. Beyond that there are a variety of techniques we might use to “insure” against this event occurring. The problem is that all of these insurance techniques have a significant cost so if the higher probability prevails and the debt ceiling issue is resolved before the deadline, we could effectively “shoot ourselves in the foot” by incurring unnecessary insurance expense. That market volatility has increased leading up to August 2nd is one of the least surprising and most anticipated developments that I can imagine. Stay tuned for more news about what, if anything, we will do to further hedge client portfolios against these unlikely events.