WHAT DO FAT TAILS LOOK LIKE?

WHAT DO FAT TAILS LOOK LIKE? Kids, I have posted about Nassim Nicholas Taleb’s assertion that people mistakenly assume that the probability of most events is described by the usual normal or “bell-shaped” curve. Taleb thinks—as did Benoit Mandelbrot—that rare events occur much more frequently than a bell curve predicts. Javier Blas in the Financial Times (December 13) reports participants in the crude oil markets are currently using the term “fat tail” more frequently than ever before. The current expected price for crude oil in 2012 is, say, about $100. But there are thought to be big risks on each side of $100. The biggest tail risk is of trouble in the Middle East or even in Russia, which would lead to a spike in oil prices to,say $200. On the downside, the main “fat-tail risk” is of a collapse in the eurozone which leads to a new worldwide recession. On each side, the way to play the risk is by means of an option (to buy or to sell). One trader is quoted as comparing the options to lottery tickets.