Chapter 24 - Tail Risk Protection for Funds of Hedge Funds

Abstract

The financial crisis of 2008 clearly showed that funds of hedge funds (FoHFs) can exhibit tail risks most investors have not been aware of. Several studies have discussed the type of tail risks FoHFs can be exposed to as well as how tail risk can be measured. However, almost none of these studies provides suggestions and methods for mitigating these tail risks. This chapter provides a dynamic hedging strategy for equity tail risks to which FoHFs are normally exposed. Given the well-documented negative correlation between equity returns and volatility indices, on option implied volatility levels, one of the simplest way to hedge against equity tail risk is to buy an out-of-the money call option on the Chicago Board Options Exchange (CBOE) Volatility Index (VIX). However, the rolling costs for buying a call option on the VIX every month are quite high. This chapter discusses a dynamic hedging strategy that minimizes the rolling costs while being able to provide tail risk protection during the equity drawdown phases occuring during the time elapsing since VIX options trading started on the CBOE in February 2006.