Explain the Concept of ‘Tail Risk’ in the Context of Customized Derivatives

Tail risk refers to the risk of an asset or portfolio experiencing extreme, low-probability events, often resulting in significant financial losses. In customized derivatives, tail risk can be magnified because the bespoke nature of the contract might specifically expose the counterparty to a highly improbable but catastrophic market scenario.

The lack of market liquidity for these unique contracts also makes hedging the tail risk much more difficult and costly.