In this article I discuss a few facts about tail risk hedging, an obvious drawback that is rarely discussed and compare a specific tail risk strategy to a popular timing strategy. Access to full article requires Premium Articles or All in One subscriptions.
Tail risk hedging is used for limiting losses in case of unexpected market moves. In theory the concept is easy to grasp but in reality using effectively tail risk hedging adds another layer of complexity to an already highly complex process.
“Tail” before “risk hedging” is used to clarify that this type of hedging deals with specifically extreme risk, or the risk arising from the tails of a distribution of returns.
In simpler words, tails risk is the risk from infrequent events and the March 2020 crash is an example of such event.
But why hedging for tail risk if historically markets have recovered from these tail events?
This is a valid question but not everyone is a passive equity investor. For some funds shorting equities, tail risk arises from market meltup or a sudden rise in a specific stock they have shorted. However, the bulk of tail risking hedging refers to left tail risk and specifically in equity markets.
Equity index put options come to mind immediately as the most popular derivative for hedging left tail risk in case of equity portfolios but there are several other derivatives that can be used, including long volatility ETPs.
Note that tail risk hedging is primarily lucrative for the sell side and the quantitative explanation is offered below. The market isn’t very efficient in pricing risk and that offers an advantage to sell side in pricing their products. The result is retail and funds end up paying a hefty premium for tail risk protection. I include data below that illustrate this effect.
There are also capacity constraints: tail risk hedging is limited by supply of counter-party risk taking. If there aren’t enough put option writers around, for example, then especially in the case of funds with large AUM tail risk hedging may not be a feasible strategy.
There is also counter-party credit risk. Organized exchanges eliminate this risk but there is remote possibility a massive left tail event may cause defaults and inability to cover obligations; it’s similar to when insurance companies fail. This is a rare event with small but finite probability. It’s the tail risk of the tail risk strategy.
Below we look at some interesting data in an effort to understand tail risk hedging and then compare the results of a tail hedging strategy to those of a timing strategy.
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Charting and backtesting program: Amibroker. Data provider: Norgate Data
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