Why is tail risk significant in risk modeling?

Tail risk is significant in risk modeling because it focuses on rare, extreme events that occur at the tails of a probability distribution, which can lead to severe financial losses. Unlike routine market fluctuations or common outcomes, tail events are characterized by their low probability but potentially catastrophic impact.

Risk models that incorporate tail risk help organizations to better understand and prepare for these extreme events, which may not be captured adequately by traditional risk measures that tend to focus on average scenarios. Understanding tail risk is crucial for effective risk management, as it ensures that strategies are in place to mitigate the potential impacts of these adverse occurrences. This consideration helps in maintaining financial stability and in making more informed decisions regarding risk exposure.