Taking the Sting out of the Tail: Hedging Against Extreme Events
March 22, 2013
Since the 2008 financial crisis, recurring volatility has driven investors to seek strategies that provide better protection, particularly in periods of extreme market stress or “tail risk.” In this paper we discuss how, when diversification falls short, tail hedging may offer a good solution.
The notion of tail risk refers to the “tail” associated with a normal (“bell curve”) distribution of returns. Most returns are clustered around the average, but some fall well beyond the average (see chart). In a normal distribution of returns, the likelihood of a tail event is extremely low. But history shows that real world returns have not always behaved like a normal distribution. For example, take the S&P 500 from January 1928 through December 2012. In a normal distribution, a negative tail event should have occurred on about 29 days since 1928. In reality, extreme losses occurred about seven times as often, on 197 days.
Portfolios are traditionally structured to cope with “normal” levels of volatility, usually in line with a long-run historical average, so portfolio construction and sources of diversification often fall short of expectations in periods of extreme market stress. The challenge is to protect against tail risk at times of crisis, while actively managing any negative carry costs associated with the protection. We believe that an effective tail-risk hedging strategy can help investors by buffering their portfolios when extreme events occur. We recommend maximizing the opportunity set by researching strategies across asset classes. For best results, we advocate an agile, active approach that dynamically allocates funds between strategies depending on current market pricing and prevailing conditions.
Tail Risk in Theory: A Normal Distribution