Comments on: Why you can’t hedge tail risk

By: joeenuf

joeenuf — Tue, 05 Jul 2011 22:56:27 +0000

many years ago, my dad read an amazing statistic in, I think the NYTimes, but it might have been some other, at the time well respected, source of news.
The statistic was that 30% of vietnam vets attempted suicide – which if you think about it for a few seconds, is an amazing number.
My dad snailmails (this is way, way before the web) the reporter, who sends him to a “source” who sends him to another source…eventually, my dad gets a Prof of Clin Psychiatry at the San Diego Veteran’s med center on the line, who, according to my dad, starts screaming, those bastards, they’ve been misquoting me for months, its 30% of Viet Vets hospitalized for acute psychosis who attempt suicide..which is roughly the same as the general population.
Or, never attribute to motive what can be explained by stupidity, or as Pascal is reputed to have said, it is easy to understand infinity, just contemplate human stupidity

By: ErnieD

ErnieD — Tue, 05 Jul 2011 15:42:37 +0000

I think there are two parts to the question,

The first part, hedging tail-risk of a defined distribution, is what Wall Street claims to have lots of products to do. They accomplish this with varying success.

The second part, is the “black swan” type of event which is a completely different animal.

How do you hedge against the Weimar Republic hyper-inflation, the destruction of your country like most of Europe and Japan saw in WW II, the take-over of your country by a foreign power, such as the Iron Curtain countries, internal revolution (France late 1700s, Iran 1979), the collapse of a banking system (US 1929-33), civil war (US 1860s), etc.

These types of events require “products” much different from anything that Wall Street purveys. Jews in Germany in the 1930s needed Swiss bank accounts, diamonds, and an exit visa from the country, similarly for the ruling elite in Iran in 1979 and France in the 1700s.

Survival in the early years of the Great Depression required no debt and lots of cash under the mattress, not in a bank. Even owning farmland didn’t necessarily help due to the massive drought and topsoil loss, partially due to poor farming practices.

Ultimately, hedging “tail risk” can involve everything from having some shorts to owning a shotgun and shells under the bed along with cans of food and gold pieces.

Bill Bernstein at http://www.efficientfrontier.com did a good piece on tail risk in about 2000 when he estimated that the best that the various retirement calculators could do for actual confidence level was about 80% instead of the 95% that most touted because the potential of major events like war and societal collapse during a lifetime does not show up in any MPT statistics.

By: jomiku

jomiku — Tue, 05 Jul 2011 00:39:38 +0000

It’s clear from looking at the comments, including my own, that we’re talking about two different forms of tail risk. One is the 3 standard deviations move from a price. That can be hedged because it can be modeled and priced. Another is what are now called black swans but which also be called that which the model doesn’t predict can happen; either the probability is too low, the risk is already hedged in the strategy being modeled or it simply can’t be anticipated. I imagine one can hedge one’s hedge one’s hedge but one can’t overcome the biases inherent in models that make one blind to unanticipated, even unimagined risk.

By: SelenesMom

SelenesMom — Mon, 04 Jul 2011 23:39:18 +0000

It looks to me as though there is a “tail risk hedge,” except that I don’t fully understand how to pull it off. If I did, I’d consider doing it myself and building near risk-free wealth.

It involves first becoming a well-known fund manager, but not necessarily one who can survive both up and down markets. Then somehow, after you blow up, like Meriwether or apparently like this Boaz Weinstein Felix mentions, you persuade people to set you back up in business anyway, and you still have a nice income.

By: Danny_Black

Danny_Black — Mon, 04 Jul 2011 06:00:48 +0000

mwwaters, the irony of course of you mentioning Howie is that his trade was predicated on a crash in house prices. He was the one making a “Big Short”. Of course he didn’t want to be losing 100s of millions a year for what would have been 3 years so he funded it with writing insurance on AAA tranches and when correlations went to one he lost a bundle.

Just goes to show you can be right about the future and still lose money.

By: y2kurtus

y2kurtus — Mon, 04 Jul 2011 00:27:58 +0000

I agree that tail risk can’t be hedged.

I think a related topic of great interest the next few weeks will be what is truely the worlds most investable ultra low risk asset. Curently the market says it’s U.S. T-bills and German Euro Bonds.

I’m on the other side of that trade… put my money into ultra-high quality equities which generate meaningful %’s of their earnings in several currencies and who’s dividends (untaxable to me in IRA’s) are higher than the 10 year treasury. Like TFF I’m more worried about the dependability of the cashflows than the day to day volitility of the principal.

By: mwwaters

mwwaters — Sun, 03 Jul 2011 06:12:01 +0000

My biggest fear is that black swan derivatives will become popular without the appropriate safeguards. Some Black Swan derivatives, for example, bet on the collapse of China. Sino-Forest shows that China is still quite opaque for the level of FDI they are getting. So, what if they’re banks become extraordinarily insolvent due to the popping property bubble and China has to bail them out, causing either hyperinflation or much higher Chinese bond yields?

In that case, any sort of derivative betting on the event acts as a weapon of mass financial destruction, as Buffett put it. Banks have to be properly hedged for the event and I’m not sure Dodd-Frank can stop another Howie Hubler loading up on supposedly AAA CDS’s or put option writing on Chinese companies. In that case, I guess we’ll find out how well the living wills actually work.

By: Uncle_Billy

Uncle_Billy — Fri, 01 Jul 2011 23:40:35 +0000

You do not really want to do this for the rest of your life, do you?! Did they promise you something really juicy? A chalet on Candy Mountain? All the stinky cheese you can eat? What? Wouldn’t you really rather be a tech evangelist or blogger over at Boing Boing?

By: jnewman

jnewman — Fri, 01 Jul 2011 21:10:04 +0000

It seems to me hedging with TBills is an alternative to investing as it is an expression of an increased marginal propensity to hoard: http://cobblehillbilly.blogspot.com/2011 /06/marginal-propensity-to-hoard.html

I suspect this is why Bill Gross: http://www.creditwritedowns.com/2011/06/ gross-education-debt-and-government-as-l ast-employer.html

and Barton Biggs: http://www.creditwritedowns.com/2011/07/ the-big-interview-with-barton-biggs.html

have both taken to talking about public investment and jobs: the private sector can not identify a realistic demand pull for future returns on investment and is thus increasingly hoarding wealth in bonds that create nothing but fiat returns.

By: djiddish98

djiddish98 — Fri, 01 Jul 2011 20:59:04 +0000

I’m glad you highlighted the ridiculousness of the Black Swan ETF, since it’s a financial oxymoron.

I would love to hear what they’re buying to protect themselves from extreme events, and then provide a hypothetical event that would destroy their value.

By: DonthelibertDem

DonthelibertDem — Fri, 01 Jul 2011 20:11:23 +0000

Maybe they’re thinking that in a Very Large Crisis, the Govt bears the Risk. So the key is to invest in Risky Investments that the Govt has some reason for saving should things go bad.

By: jbernar

jbernar — Fri, 01 Jul 2011 20:00:58 +0000

You’re right, of course. It seems so obvious…

The fact that this is even being discussed now is proof that any effort to promote insurance against catastrophic risk is the triumph of greed over experience. There needs to be some corresponding catastrophic punishment for non-performance, like: if there is a catastrophic event and you can’t pay the insurance you have sold, you will be drawn-and-quartered. We’ll see how eager hedge fund managers are to pitch that.

By: jose_invests

jose_invests — Fri, 01 Jul 2011 18:12:32 +0000

James Montier at GMO published an excellent and brief white paper titled “An Ode to the Joy of Cash” analyzing various tail risk strategies, including cash. Its a good read, with real numbers. The pdf can be found on the GMO website.

By: BRM_3

BRM_3 — Fri, 01 Jul 2011 16:56:27 +0000

The number of US-based institutional investors that investigated (and continue to investigate) tail-risk hedging is absolutely massive. Having very recently left a role as a derivatives specialists (listed index option-based strategies) at a $300B asset management group I can assure you that the number of accounts that we ran some form of tail-risk overlay for become substantial. Yes, the dedicated collateral to those overlays in tiny because of the efficiency of the margin requirements attached to listed index options, but the notional values they are structured to protect are substantial, and growing.

There is no such thing as a cheap put, true, and that is what many misguided clients came to us looking for. Still, the idea that the industry hasn’t evolved to the point where large asset allocators are now sophisticated enough to evaluate and implement option-based hedging approaches just isn’t correct. From targeted volatility funds to using options spreads like collars, put-spread collars, and condors to fund long put positions. These strategies have real and growing traction.

By: jomiku

jomiku — Fri, 01 Jul 2011 16:53:45 +0000

In property, they have sold “all risks” coverage so I suppose one need not identify any tail risk, just that there is risk. I wonder if the biggest question is whether that insurance will pay. It won’t if the tail risk is the sun blows up, but then you won’t be making claims either. The question, I think, is whether it’s sensible to buy the insurance. How do you price it? You as provider and you as buyer. If it’s sold as a claim on a stock of expected ultra-safe aspects, then it has to be expensive: you’re buying into a pool, aren’t you? That pool can’t do much because more return would put it at risk, so the expected yield should be low – unless you’re being sold fake ultra-safe stuff.

How do you as a buyer know a price? The next tail event might not affect you. It might wipe you out anyway. What if you’re hit in one area but not the area you’ve insured? Do people buy insurance for meteor strikes? How many buy trip insurance or flight coverage in case of a crash? We do all sorts of risky things everyday and yet most people don’t have much life insurance. If you have lots of money, maybe it makes more sense to buy art or jewels. Too many questions for this to be sensible.