New Delhi: Human beings shape their beliefs and base propagation and survival strategies on what they observe in nature and in everyday life. Right up to the Middle Ages, the conventional belief was that all swans are white because only white swans existed in Europe. Nobody had seen a swan of another colour and no one thought otherwise. That was until a black swan was observed in Australia. The Dutch navigator Willem de Vlamingh was among the first Europeans to see black swans as he sailed up what subsequently he named the Swan River in the late seventeenth century. And by that observation the age-old belief that all swans are white was negated. This created turmoil among ornithologists specifically and in the scientific world generally where it was also appreciated that a single rare event can falsify established theory.

The notion of a rare, unanticipated event has significant import in the world of financial risk management. Nassim Nicholas Taleb, a fund manager and self-proclaimed empiricist, brought this into mass public consciousness in 2007 with his book, The Black Swan: The Impact of the Highly Improbable. Taleb postulates a Black Swan as an event that, firstly, is an outlier. It lies outside the realm of regular expectations because nothing in the past convincingly can point to its possibility. Secondly, it carries an extreme impact. Thirdly, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable. The third criterion seems improvised and originates from his earlier book, Fooled by Randomness.

Human beings are hardwired and genetically programmed to live in a "normalized world" where they plan for low volatility and high predictability. This assumed stability is essential for human civilization to invest in the future with reasonable certainty and forms the bedrock of progress. In statistics, this is called the probability of normal distribution where most of the risk/ return projections are based on 1 sigma movements from the mean of the expected gain. Hence, when rare, high sigma events, eloquently called Black Swans, occur, financial managers are ill-prepared to mitigate losses, not to speak of profiting from these occurrences. This can lead to sudden implosions where the largest institutions or the smartest people can rapidly go bankrupt.

Last week, such an event happened with enormous consequences in the financial sphere and now impacting the real world of ordinary people. On Thursday, 15 January, the Swiss National Bank (SNB) announced that it would immediately delink the Swiss Franc (CHF) from the Euro. In other words, the previous cap of 1.20 CHF to the Euro would not apply and the Swiss currency would be permitted to appreciate unhampered. Instantly, the CHF rose close to 40 percent (it peaked at 42) against the Euro, sending global currency and bond markets into a tailspin.

The first of Taleb’s three-set criteria of a Black Swan event was validated. The event of the CHF being “depegged” from Euro was thought impossible by financial markets. For the last three years, SNB had made the peg the cornerstone of Switzerland’s monetary policy; as recently as Monday, 11 January, SNB had reaffirmed the peg. Breaking away caught financial markets completely unawares and chaos ensued.

The first casualties were a bunch of retail currency brokerages that allow retail “investors” to play the foreign currency market by providing leverage as high as 100:1 (i.e., for every US$1 that the customer brings, they can borrow $100 for trading). Leverage is a rocket fuel in a rising market where it helps multiply the return on your equity. But in a wrong-way bet like the CHF appreciation, even a small movement in the opposite direction can wipe out the customer’s equity. This is what happened. In a moment, customer accounts had negative balances exceeding the equity capital of the brokerages. Brokerages went belly up.

FXCM, the largest retail currency broker in the US, had to be bailed out by an investment manager who injected USD 300 million. Many large banks have lost to the tune of USD 400 million (and counting) on currency hedges they sold. A large hedge fund with a corpus of USD 800 million has gone bust with short positions in CHF.

Even the middle class has been singed. In Poland, the Czech Republic, Slovakia and some other East European states, people were accustomed to taking home loans in CHF which attracted lower interest rates than local currencies. Unwittingly, homeowners were carrying a currency risk as their income was in local currency and the loans had to be repaid in CHF. As long as the CHF was stable, it was good going. But when the CHF appreciated, the loans instantly increased by a third in local currency. This has raised the spectre of large mortgage defaults; local governments have been forced to intervene. Meanwhile, Swiss exports and tourism have overnight become 30-plus percent more expensive. The damage and losses from this event are still being assessed. Taleb's second criterion has also been validated; the impact has been widespread and severe.

Finally, in the aftermath of the sighting of the Black Swan, a whole cottage industry has sprung up. Many know-all analysts are now pedantically rationalizing the circumstances and the logic of the Swiss National Bank action post-facto. The reality is that even moments before the SNB announcement, no one had a clue about it and the repercussions. None of these wise men (and a few women!) in their wildest nightmares would have predicted this even as an improbable possibility. On his third supposition as well, Nassim Nicholas Taleb stands vindicated.

The Swiss Franc saga of last week underscores the reality of extreme events and the havoc they can wreak on “normal” plans. Financial risk managers have to realize that Black Swan events do occur (the so-called 100 sigma events seem to be occurring with startling frequency since the Long Term Capital Management debacle of 1998) and that they have to model such events. Having a diversified, adequately-hedged portfolio may make all the difference between financial survival and death.

Postscript: Would the 50 percent decline in oil prices over the last six months qualify as a Black Swan event? Probably not, given their somewhat more gradual and orderly decline. Perhaps, it is a Grey Swan event!

Editor’s Note: Prime Minister Narendra Modi has no interest in bludgeoning the media into submission; he prefers his work to do the talking. But sections of his government have not given up on the old ways of the establishment to harass the press. A. B. Mohapatra, a respected journalist, edits and publishes the defence magazine, Strategic Affairs. He has received notice from an obscure government library in Chennai to furnish backdated and future copies of the magazine or face prosecution. No one will succumb to such threats; they will merely boomerang on the government.