Is it possible to hedge tail risk?

By Felix Salmon
July 13, 2010
lose between 12% and 18% per year playing in the options market.

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Pine River Capital Management has just launched a new hedge fund. You’ll like the fee structure: there’s no incentive fee at all, which makes for a welcome change from the standard structure where the fund manager takes 20% of the profits. But you might not like the performance: it’s designed to lose between 12% and 18% per year playing in the options market.

Why would anybody invest in such a product? As insurance: the idea behind the fund is that it will soar in the event of extreme market chaos. It’s a productized form of tail risk hedging, and it gives a pretty good indication of how difficult and how expensive true tail-risk hedging really is. Especially since there’s no guarantee that the fund will actually work as hoped.

Deutsche Bank’s Ken Akoundi has a great 21-page primer on tail risk hedging, which lays out the various options. For those of us who rely on old-fashioned diversification across asset classes, there’s this handy cut-out-and-keep chart:

correlation.tiff

What you’re looking for here is numbers less than zero. At zero, there’s no correlation at all: for instance there’s no correlation between U.S. bonds and managed commodity futures. Less than zero, and you’re likely to at least partially make up in one asset class’s gains what you lose in another asset class: for instance, if you’re long U.S. equities and also long volatility, then when stocks crash and volatility spikes, you’ll do better than if you just held stocks on their own. The correlation between stocks and volatility is very low, at -0.65.

The other asset class which has a negative correlation with stocks is, again, those managed commodity futures — which are not to be confused with commodities themselves. Those have a positive correlation. It’s worth noting that diversifying internationally doesn’t seem to help at all: U.S. stocks have a +0.93 correlation with foreign stocks.

The problem with trying to invest in asset classes like volatility or managed commodity futures, of course, is that it’s expensive and difficult to do so. You can’t just go out and buy an ETF. Deutsche Bank has its own proprietary products, with names like ELVIS and EMERALD, which try to give pension funds the ability to invest in these asset classes, but again it’s hard to know whether they’ll work ex ante. As everybody knows, in a crisis, correlations all tend to zoom towards 1.

So what other options are there for hedging tail risk? Akoundi presents a pretty long list. There are complex things like variance swaps, inflation floor agreements, and tail risk protection indices, but there are also simpler ideas like buying out-of-the-money index puts, or buying credit protection in the CDS market. And then there are the kind of strategies which ask “if there’s a crisis, what’s likely to happen to certain assets”: Akoundi cites as examples the “sovereign risk commodity hedge” of buying calls on gold and puts on oil and aluminum, or the “sovereign risk rates hedge” of buying something known as a  low‐strike receiver swaption in USD.

I’m not a huge fan of these strategies, because they only work if (a) there’s a crisis like the crisis you think might come, and (b) it plays out in the way that you think it will. Crises, of course, have a way of being unexpected, both in terms of where they come from and how they play out. That’s why someone like Peter Schiff could position his investors for the coming crisis, see the crisis materialize, and still lose his investors lots of money.

There’s another way to deal with tail risk, and that’s the Nassim Taleb approach: put 90% of your money in Treasury bills, and then invest the other 10% in options and other instruments which normally go down but which are likely to pay off massively if there’s a crisis or a major spike in inflation. If they don’t, well, at least you still have 90% of your money in Treasury bills. But that kind of strategy is much harder to pull off if the bulk of your money is in stocks rather than risk-free investments.

Ultimately, tail risk is something that’s very expensive to hedge, and attempting to do so might well fail. It’s worth thinking about, but some things, while great in theory, just don’t work so well in practice. And I don’t think there are any tried-and-tested tail-risk hedging strategies.

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