DEFINITION of ‘Grey Swan’
An event that can be anticipated to a certain degree, but is considered unlikely to occur and may have a sizable impact on the valuation of a security or the health of the overall market if it does occur. A grey swan event is unlike a black swan event whose total impact is difficult to predict. Despite the possibility of determining the properties and potential impact of such an event, it is difficult to create precise calculations regarding the total impact.
BREAKING DOWN ‘Grey Swan’
The term “black swan” was coined by Nassim Nicholas Taleb to describe the uncertainty and risk posed by unpredictable events. Grey swan events, which are derived from the black swan concept, may include earthquakes and even events like the Great Depression. While analysts can look at the impacts that similar events had across history, the exact extent of damage and risk cannot be calculated.
A black swan is an event or occurrence that deviates beyond what is normally expected of a situation and is extremely difficult to predict; the term was popularized by Nassim Nicholas Taleb, a finance professor, writer and former Wall Street trader. Black swan events are typically random and are unexpected.
BREAKING DOWN ‘Black Swan’
The idea of a black swan event was pioneered by the financial professional turned writer Nassim Nicholas Taleb after the results of the 2008 financial crisis. Taleb argued that black swan events are impossible to predict yet have catastrophic ramifications. Therefore, it is important for people to always assume a black swan event is a possibility, whatever it may be, and to plan accordingly. He also used the 2008 financial crisis and the idea of black swan events to point out if a broken system is allowed to fail, it actually strengthens it against the catastrophe of future black swan events.
Taleb spent 21 years on Wall Street as a quant trader, developing the computer models for financial institutions. Since that time, he has written a long-form essay broken into three books: “The Black Swan: The Impact of the Highly Improbable,” “Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets” and “Antifragile: Things That Gain from Disorder.” He has been a distinguished professor of risk engineering at NYU’s School of Engineering and written over 45 peer-reviewed papers.
Examples of Past Black Swan Events
The financial crash of the U.S. housing market during the 2008 crisis is one of the most recent and well-known black swan events as of 2016. The effect of the crash was catastrophic and global, and only a few outliers were able to predict it happening. Also in 2008, Zimbabwe had the worst case of hyperinflation in the 21st century with a peak inflation rate of more than 79.6 billion percent. An inflation level of that amount is nearly impossible to predict and can easily ruin a country financially.
The dot-com bubble of 2001 is another black swan event that has similarities to the 2008 financial crisis. America was enjoying rapid economic growth and increases in private wealth before the economy catastrophically collapsed. Since the Internet was at its infancy in terms of commercial use, various investment funds were investing in technology companies with inflated valuations and no market traction. When these companies folded, the funds were hit hard, and the downside risk was passed onto the investors. The digital frontier was new, and therefore it was nearly impossible to predict the collapse.
As another example, the previously successful hedge fund Long Term Capital Management (LTCM) was driven into the ground in 1998 as a result of the ripple effect caused by the Russian government’s debt default, something the company’s computer models could not have predicted.