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/

Private equity: One careful owner?

DISCOUNTED prices, outdated models and a glut of inventory. Customers can tell plenty about the state of the auto industry while kicking tyres at a used-car dealership. The same is true for the second-hand market for private-equity stakes. What used to be a tiny part of the industry has flourished (see chart).

“Secondary” stakes change hands when investors, who typically agree to lock up their money for a decade, decide to sell early. Triago, a firm that arranges secondary transactions, reckons that deals worth $25 billion will take place in 2011, up by 25% from last year’s record.

Banks and insurers are largely responsible, since they need to sell their investments in private equity and free capital to comply with an onslaught of new regulations, such as Basel 3 and Solvency II in Europe, and the Volcker rule in America. Cash-strapped European banks are also eager to peddle their private-equity investments. In August HSH Nordbank, a German bank, sold a €620m ($1 billion) portfolio that included stakes in well-known firms such as Carlyle and KKR.

A flurry of secondary activity has been predicted for years. But until recently only the most desperate investors wanted to offload their stakes at rock-bottom prices. Transactions have picked up because sellers can now get better prices. Neil Campbell of Tullett Prebon, an interdealer broker, says that investors today can expect around 95 cents on the dollar for many of their stakes, compared with only 60 cents in 2009. Some assets have doubled in price in the past year.

Prices have risen because of a glut of capital that firms specialising in the secondary market, such as Coller Capital and Harbourvest, have raised to take advantage of the opportunity to buy. These firms aren’t the only ones shopping. Some pensions and funds of funds have begun to use the secondary market to invest in promising funds or regions.

Some say that the secondary market’s growth shows that institutional investors are becoming more familiar with private equity as an asset class—and are becoming more aware of its attractions. It helps that secondaries can be bought and sold more easily than ever before. But transactions in them are still more arduous to complete, not to mention more opaque, than other investments. Unlike face-to-face bargaining over a dodgy motor, deals are negotiated through an intermediary. Attempts to launch exchanges and derivative products, which would make for more transparent pricing, have not taken off.

Mathieu Dréan of Triago predicts that by 2015 the annual tally will be $75 billion-worth of secondary transactions annually. The struggles of the private-equity industry will partly fuel this growth. Buy-out firms bought too many companies at top prices. They must now wait until the economy improves to sell or float them and return money to impatient investors. Private-equity firms are now holding on to companies for five years on average, compared with three-and-a-half years in 2007. Some investors don’t want to wait that long to pocket returns. They are turning to the secondary market to hand in the keys for their old model and grab what cash they can.

Source: http://www.economist.com/node/21541430