What is meant by tail risk?

Tail risk refers specifically to the risk of extreme loss events that occur in the far tails of a probability distribution of returns. In finance and risk management, the "tails" of a distribution represent the far ends, where the probability of extreme outcomes—both positive and negative—lies. Tail risk focuses particularly on the negative side, where occurrences may lead to significant losses that are much greater than what might be anticipated based on more typical market behavior.

This concept is crucial because while most risk management strategies might consider average or expected outcomes, tail risk emphasizes that there exists a non-negligible probability for catastrophic events, which can lead to substantial financial impact. Understanding tail risk is vital for portfolio management, as it helps investors and risk managers prepare for and mitigate the effects of rare but severe market movements.

Other options do not capture the essence of tail risk. For instance, one option discusses minor fluctuations, which are not of concern when assessing extreme events—these fluctuations lie within the normal range of a distribution. Other options mention unexpected high returns or stable returns, which do not relate to the definition of tail risk, as they either imply scenarios that are standard deviations away from the mean or opposite ends of risk exposure.