The risk that arises from loss-making events with regards to an asset or portfolio of assets. This usually happens when there is a move exceeding 3 standard deviations from its current price (above the risk of a normal distribution).
Fat tail risk can be hedged (tail risk hedging) by a variety of means including maintaining a constant asset allocation and complementing that with the use of derivatives such as currency options, interest rate options, equity puts, credit protection (credit default swaps, etc.), and VIX futures. However, hedging the fat tail risk using derivatives brings about its own risks. It can be difficult to close out derivatives positions in specific market conditions, and with specific types of derivatives, and hence more than the principal of the investment could be lost in the process.
The fat tail risk (the risk of a fat tail) is also known as tail risk.
