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Understanding Tail Risk: Skewness & Kurtosis

Sep 2, 2011 Marc Odo

Over the last decade or more there has been an increased awareness of “tail risk”- those extreme events in the market that have an outsized impact upon an investment. By definition, tail events are supposed to be infrequent, but these shocks are happening much more frequently and are more extreme than a lot of investors anticipated. The LTCM crisis, and Asian meltdown, the dot-com bust, the credit crisis, and most recently the debt ceiling showdown have whipsawed investors. After these shocks, the feeling is that the traditional measure of risk- standard deviation- is inadequate in explaining the total nature of the risk of investing.

Tail risk has traditionally been measured by metrics known as skewness and kurtosis, and should be considered in conjunction with the more widely used return and standard deviation metrics. Skewness measures whether or not a distribution of returns is symmetrical, or if it is tilted or pulled one direction or the other by the length of those tail events. Kurtosis measures where the volatility comes from in an investment. Is the volatility driven by a few extreme events or is the volatility “spread out” over the full range of a distribution?

Many people struggle with the ideas of skewness and kurtosis, because they are mathematically sophisticated and intellectually challenging. The topics of skewness and kurtosis are much too deep to be addressed in a short blog post, but we wanted to make you aware of the resources available to help you with your understanding of tail risk. I recently wrote a white paper/case study on the topic that attempts to explain in plain English and with helpful illustrations just what skewness and kurtosis are. I look at the different asset classes to give you a feel for the typical skewness and kurtosis values seen in the markets. Finally, I take a closer look at hedge funds in the paper.

In addition to the white paper on the topic, I will be sharing this same content during a presentation at our upcoming client conference. There are still seats available for the conference, and the range of topics we will be discussing will be interesting and relevant to Zephyr users. Sign-up information is here, we hope to see you there!

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