Pricing Risk

Hedge funds, and arbitrageurs of all hues, make money by identifying pricing inefficiencies -- differences in prices between sets of assets that should have identical prices.: one buys (or promises to buy) the cheaper and sell (or promises to sell) the more expensive and makes money in the exchange, while moving prices so as to reduce the pricing gap and increase pricing efficiency.

It seems that the pricing inefficiency that has been exploited  by many hedge funds of late is that financial risk has been underpriced: hedge funds could get low interest loans to invest in risky financial deals, winning because of the gap between the low interest on loans underpriced by banks that did not price the risk correctly and the high income from risky transactions. Same can be said of investments in securitized mortgages: Intermediaries made money by selling high risk mortgage securities at prices that reflected a lower risk assessment. 

When the arbitrage is about misaligned prices of equivalent assets then the movement of prices due to offer and demand closes the gap, in  a self correcting process. If the arbitrage is about a misperception of risk, then the correction happens when risks materialize, lowering the value of the risky assets. But if the risks in question are about very rare but very consequential events, such as the crash in house prices, then the correction will happen rarely and the correction will entail a large shift in asset prices. 

Of course, one can ask why risk is mispriced, and explanations abound: the irrational theory of the economic agent (Tverski and Kahaner), the confusion between aleatory risk and epistemic uncertainty that seems to be deeply rooted in economic models for risk pricing, etc. But even in a perfect, rational world, if information comes in rare, discrete but very significant events, then the "correct" pricing of risk will change rarely but abruptly.