Managing Tail Risk Part I: Option-Based Hedging

Abstract

There is nothing like a market crash to focus the mind on the importance of risk management and, more specifically, tail risk management. Because tail events are generally systemic in nature and are characterised by elevated correlations and liquidity squeezes, effective tail risk management is not just a diversification exercise but rather requires explicit and specialised strategies. The natural question that arises then is how do you create an optimal tail risk management strategy? Most studies identify four categories of tail risk management strategy: option-based hedging, asset allocation, dynamic trading and defensive equity. Within each category, we then find a number of strategies available to investors for managing tail risk. Unfortunately, it remains an open question as to which strategy works best for a given investment scenario, or if there even exists a universally optimal strategy to begin with. We attempt to answer this question by analysing a range of commonly used tail risk management strategies in a South African market setting. However, given the breadth of the four available strategy categories, we split our research on this topic into two parts. In this Part I, we firstly examine and quantify the tail risk inherent in South African markets. This is done through a review the long-term history of equity and bond market drawdowns. Thereafter, we discuss nine core principles that are applicable to all candidate strategies and that define good tail risk management. Finally, we provide a comprehensive analysis of option-based tail hedging strategies. The concepts of defensive, offensive, active and indirect tail hedging are discussed at length and examples of each are implemented on historical market data.