The Challenges in Hedging Tail Risk

If there’s one word investors use to describe the markets over the past few years, it’s unpredictable. Unforeseen events were everywhere.

Last year we had the Japanese tsunami and the Arab Spring, followed by the debt ceiling standoff in the United States and the subsequent credit rating downgrade. Even for a “predictable” event, like the European sovereign debt crisis, each twist seemed to catch investors off guard.

What will take us by surprise in 2012? Will it be military conflict in the Middle East, a slowdown in growth in China, continued stress in Europe, or something else we are not yet thinking about?

This uncertainty is unwelcome to those still recovering from the financial crisis, which not only frayed investors’ nerves, but left many portfolios in a precarious state. Some investors, like underfunded pension funds, have limited ability to withstand another market shock. Given this backdrop and these fears, “tail risk” hedging, or protecting investment portfolios against extreme negative moves in the market, has been a frequent topic of conversation among market participants.

Buying put options is currently the most popular form of “tail risk” hedging. Despite the growing demand to buy long-term put options from both institutional and individual investors, fewer and fewer market participants are willing or able to sell these options. Whereas an option buyer’s risk is limited to the premium they pay, an option seller has much greater risk.

With the coming arrival of the Volcker Rule, which seeks to reduce excessive risk at banks, banks need to decrease the amount of long-dated options they will sell. In addition, regulatory changes have increased the amount of collateral required for these trades, further constraining the number of option sellers. One example is Berkshire Hathaway, which has historically been a significant seller of long-dated put options on the United States equity markets. Berkshire stated in its annual letter than it plans to stop selling options because of regulatory changes.

The increased demand to buy put options (which are priced in terms of implied volatility), coupled with a lack of people willing and able to sell them, has led to excessively high volatility prices, especially in longer-dated maturities.

With the increase in the price of volatility, the cost of portfolio protection has also increased, causing prospective hedgers to often overpay for this insurance. Consider the price of general insurance (home, medical, car, flood, etc.) as a simple example. People buy this type of insurance to protect against the loss from a particular event. Typically, buying it is not expensive because the insurance will be paid out infrequently, if at all.

In the event of the loss, however, the insurance buyer can expect to be paid much more than the annual cost of the insurance. Unfortunately, we cannot currently say the same thing about insuring a stock portfolio against a major loss. For instance, it would cost nearly 4 percent in premium to buy a put option that starts to pay off after the market falls 15 percent over a one-year period. Because of this high cost, the option would lose money until the market fell by 19 percent. And even if the market falls further and the option pays off, the return on premium will be much lower than in the example of general insurance.

As another example of the high cost to buy portfolio protection, consider the price of call options (which benefit from a market rally) relative to the price of put options (which benefit from a market crash). For the same amount of premium, an investor could buy 10 call options on the Standard & Poor’s 500 index expiring in six-months with a strike price that is 15 percent above current levels, or just one put option at strike price 15 percent below the current levels.

For investors trying to reach a certain return target, this high cost can be a constant drag on returns, preventing them from meeting return expectations. As seen in the example above, imagine reducing your returns by 4 percent every year to pay for this down-side protection. These types of investors would be better off finding other ways of reducing portfolio risk. Indeed, there are ways for investors with long-dated capital to sell volatility in a protected manner, thereby earning the high premium themselves.

As we continue to experience bouts of volatility in the market, investors will keep searching (unsuccessfully) for the “silver bullet” for hedging tail risk in the financial markets. But when volatility is high, like it was last year, and options become expensive, investors need to pay attention to the costs of protection they are buying. Otherwise, they risk paying too much and missing their return targets even in a rallying market.

Source: http://dealbook.nytimes.com/2012/04/20/the-challenges-in-hedging-tail-risk/