What does tail risk refer to in finance?

Tail risk in finance specifically refers to the risk of significant price movements that occur in the extreme ends (the tails) of the probability distribution, which are not predicted by standard models that typically assume a normal distribution of asset returns. This means that tail risk focuses on the possibility of unexpected and severe outcomes that have low probabilities of occurrence.

Choice B captures this concept accurately by highlighting the risk of more actual events happening in the tails of the distribution than anticipated. In other words, it underscores the potential for extreme outcomes that are not adequately addressed in traditional risk assessments, which often fail to account for fat tails associated with actual market returns. This risk is particularly relevant during times of market stress or systemic crises, where rare and significant losses can become more likely than projected.

In contrast, the other options do not correctly encapsulate the essence of tail risk. For instance, the first option speaks about substantial losses from events in the core of the distribution, which is not what tail risk entails. The third choice relates to low variability in asset returns, which is more about stability rather than the potential for extreme events. Lastly, while correlated events occurring simultaneously can represent systematic risks, it does not directly define tail risk or its potential for unexpected large losses in the tails of