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/

Ever hopeful: Investors approach 2012 with cautious optimism

INVESTORS nearly always enter a new year with a sense of hope. The mistakes of the previous year—the bad share picks, the wrong guesses on exchange-rate movements—are forgotten. New cash is put to work and there is often a “January effect” as share prices rise.

It would be no surprise if history repeated itself in 2012. True, Europe may already be in recession and the region’s politicians have not yet come up with a solution to the sovereign-debt crisis. But 2011 was such a dismal year for European equities that many investors must hope that the bad news is already in the price.

After all, equities look more attractive than government bonds. Ten-year German bonds yield less than 2%; German shares have a yield of 3.6%, with the prospect of dividend growth thrown in. “Trailing” price-earnings ratios in Europe are barely in the double digits; in Germany the multiple is under ten. And the corporate sector is in good shape, having generated high margins in recent years and built up cash on its balance-sheet.

Investors can be pretty sure about the direction of monetary policy. The Federal Reserve has already indicated that it will not raise rates, and another round of quantitative easing might be introduced if the American economy wobbles. The Bank of England seems likely to follow a similar path. In Europe it is hard to see the European Central Bank repeating its 2011 mistake, when it raised rates prematurely; further cuts are possible. The developing world will probably present a more mixed picture, but easing will be more common than tightening.

Central banks can be so supportive in part because headline inflation rates are expected to fall, as the commodity-price rises seen in early 2011 slip out of the annual comparisons. But central banks will also be conscious of the need to offset the effects of fiscal policy, which is likely to be contractionary. America may have reached a short-term deal on extending the payroll-tax cut, but austerity is likely to hold sway across Europe as the region seeks to reassure investors (and German voters) about its long-term fiscal probity.

It is this issue that suggests that any initial investor optimism may be tempered as 2012 unfolds. Like children asked to eat spinach for breakfast, lunch and dinner, it is not clear how long voters will submit to a diet of austerity. The implicit deal between northern and southern euro-zone countries—bail-outs in return for deficit reduction—is unpopular with electorates on both sides. The so-called “tail risk” of a euro-zone break-up may not materialise, but it will not go away either.

Nor will the political outlook in America necessarily be helpful. Markets traditionally favour Republican candidates. But were the Republicans to take control of the presidency and both houses of Congress, there would be the prospect of aggressive fiscal tightening in 2013, along with a political leadership hostile to further quantitative easing. Meanwhile, to shore up his political base, President Barack Obama might amplify the millionaire-bashing theme of his re-election campaign.

Geopolitical risks could undermine the market, too. The Middle East remains volatile. Egypt’s revolution could go sour, Syria is a charnel-house and Iran is prone to sudden eruptions.

The fundamental problem that has dogged the economy, and equity markets, since 2008 will remain. Growth is likely to be slow as economies emerge from a debt crisis. Authorities can intervene to prevent a repeat of the Depression but the result is still likely to be sluggish rebounds with more frequent recessions. Add in the effect of high commodity prices (a consequence of the developing world’s increased importance) and it is hard to generate the kind of multi-year rally that marked the 1980s and 1990s.

This does not mean investors cannot make money. Even Japan has had some 50% rallies within its long bear market. But it does mean that “buy and hold” is not necessarily a winning strategy.

At the start of 2011 almost everyone (with honourable exceptions, such as the strategy team at Société Générale) was bullish. The outcome was deeply disappointing. As 2012 begins, the mood is more restrained. A Bank of America Merrill Lynch survey in December found that 8% of fund managers were overweight equities (relative to their normal portfolio allocation). Such caution looks realistic.

Source: http://www.economist.com/node/21542218