Integrating Event Risk in Portfolio Construction
The market developments of 2001 and 2002, when five to six standard deviation events repeatedly occurred one after another, shocked many investors. They were surprised because they viewed the market through the lens of normal distribution, in which the probability of an event more than three standard deviations from the mean approaches zero. When considering short-term market risk exposure, a normal distribution is a reasonable approximation. But when considering credit risks, default events don’t fit easily onto a bell curve. This is because there are more default events than normal distribution allows for. This situation is described by another kind of distribution curve ...