The dreaded fat tail...

Globalization, greater financial integration and the substantial improvement in cross border flow of capital has led to an explosion in financial innovation and the creation of a substantial amount of new wealth. Securitization combined with novel and sometimes exotic derivative products such as credit default swaps go a long way in explaining why liquidity in the markets have not dried up despite relatively high interest rates and an inverted yield curve both in the U.S. and the U.K. This is all very nice and dandy when things are going in the right direction. Correlations between markets and across asset classes tend to be relatively weak during an ascent and when volatility is subdued. But this can change rapidly when a fat tail event materializes. Take the Chinese single day drop of 9% at the end of February. Volatility spiked to record levels together with correlations, sending global markets on a tail spin. A complacent market was caught by surprise. In such a highly integrated global market, one cannot fail to ponder about the potentially disastrous repercussions of an unexpected catastrophic event.