Tail Risk Hedging Research Articles

Research on Tail Risk Hedging in the Digital Asset Market

In recent years, the digital asset market has experienced rapid growth, but at the same time, its implicit tail risks have gradually raised concerns, especially amidst the global economic downturn caused by the pandemic. This paper aims to study tail risks and propose hedging strategies. Based on the GARCH and VaR models, this paper uses weekly return data from July 2017 to December 2021 for Bitcoin digital cryptocurrency and traditional non-digital asset market indices such as stocks, bonds, gold, and commodities. Utilizing EViews and Excel, the study explores tail risk measurement and portfolio diversification effects in the digital asset market. The main findings are as follows: (1) During the sample period, cryptocurrency returns exhibited significant volatility, with weak correlations with returns from traditional non-digital assets. Further analysis revealed strong hedging effects of digital assets against the bond market but weaker effects against the gold and stock markets, as well as commodity markets; (2) Cryptocurrency in traditional investment portfolios can enhance the risk-return ratio by adding it to the asset mix.

Leveraging defence into offence: enhancing absolute and risk-adjusted equity returns with tail risk management overlays

ABSTRACT Research has shown that tail risk hedging using explicit option purchases and trend-following effectively mitigate equity tail risk. This paper demonstrates that these defensive qualities can be leveraged into offence: overlaying a two-pronged tail risk management strategy that employs both option-based tail risk hedging and trend-following has empirically enhanced absolute and risk-adjusted returns relative to a buy-and-hold equity portfolio. Option-based tail risk hedging has empirically mitigated equity risk best during market crashes, while trend-following has notably supported equity during slower bear markets. In combination, and when overlayed onto equity, the resulting portfolio reliably outperformed equity during the most significant drawdown episodes suffered over the period under investigation and broadly maintained this advantage during equity bull markets.

Misleading Returns: How Ignoring Cash Flows Can Result in Performance Measurement Errors

This article discusses how the traditional approach of measuring performance using time-weighted compounded returns can lead to grossly misleading conclusions in the context of two examples of practical interest. First, the authors show how measuring tail-risk hedging performance using only compounded returns, rather than both returns and timing of cash flows in the context of the underlying portfolio, can lead to erroneous conclusions about the value added by such hedges. Second, they show how measuring performance using compounded returns alone and ignoring timing and size of investment flows can result in contradictory conclusions about the long-term profitability of such investments, using the ARKK exchange-traded fund as an example. They conclude that a more complete approach to performance measurement is essential for investors to not be misled by oversimplified metrics, such as compounded returns.

Optimization-based tail risk hedging of the S&P 500 index

In this paper, we present a mixed risk-return optimization framework for selecting long put option positions for hedging the tail risk of investments in the S&P 500 index. A tractable formulation is developed by constructing hypothetical portfolios that are constantly rolling put options. Variance and sample CVaR are used as risk measures. The models are tested against out-of-sample historical S&P 500 index values as well as the values of the index paired with long put options of varying strike prices. The optimized hedged portfolio could provide sufficient protection in market downturns while not losing significant return the long horizons. This is achieved by dynamically adjusting the put option compositions to market trends in a timely manner. Allocations to different put options are analyzed in various market trends and investor risk aversion levels. The strategy overcomes the traditional drawbacks of protective put strategies and outperforms both directly investing in the underlying asset and holding a constant long position in a particular put option.

The equity-oil hedge: A comparison between volatility and alternative risk frameworks

This paper investigates alternatives to the conventional minimum-variance framework for hedging equity risks with crude oil. Specifically, the optimal hedge ratios are calculated for various risk objectives such as volatility, semivariance, and tail risk. The hedging efficacy is assessed for BRIC stocks and aggregated market indices. The results show that the optimal hedge ratios differ by strategy, and hedging efficacy varies across risk metrics, equity indices, and time periods. Semivariance and tail risk hedging are more effective than volatility risk hedging, but more expensive. Oil exporters (Brazil and Russia) outperform importers (India and China) in terms of hedging effectiveness. Hedging costs are lower during COVID-19 than during the global financial crisis. It is critical to capture volatility dynamics for hedging volatility, downside, and tail risk. Over-hedging could significantly increase the risk of an equity-oil-hedged portfolio. The findings contribute to a better understanding of oil’s risk hedging capacity for equity indices, which will be of interest to financial market participants, corporations, and regulators.

Scientific Investing in the Real World: Unifying the Extremes: Randomness Determinism Causality : Black Swan & Tail Risk Hedging Black Swan, Tail Risk Hedging, Convexity, Causality, Dynamics in Financial Market Causal Adjusted Randomized Factor Investing

Scientific Investing in the Real World: Unifying the Extremes: Randomness Determinism Causality : Black Swan & Tail Risk Hedging Black Swan, Tail Risk Hedging, Convexity, Causality, Dynamics in Financial Market Causal Adjusted Randomized Factor Investing

Tail Risk Hedging in a Low-Rate Environment

In a low-rate environment, government bonds may not mitigate equity risk as well as they have in the past. This structural shift has profound implications for asset allocation. Historically, the expected return of government bonds has been positive, <i>and</i> they have mitigated downside risk. In other words, they have offered something even better than free insurance: they have <i>paid</i> investors to buy insurance. In contrast, many option-based protection strategies are costly. Unlike government bonds, options almost always come with a negative expected return. But with real yields on most government bonds in negative territory, the tradeoffs may have changed. To control for downside risk in a low-rate environment, should asset allocators sell stocks to buy more government bonds, or should they keep a high(er) stock allocation and “hedge the tails”? We show that the answer depends on both your view on bonds and <i>how</i> tail risk hedging is implemented. Adding a delta-hedging program can significantly reduce, but not eliminate, the cost of tail risk hedging in addition to reducing path dependent equity exposure. The ultimate benefit of a tail risk hedging program to a multi-asset investor increases the more bearish you are on bonds.

Multiple Moderation Process of the Tail-Risk Hedging Managers

Multiple Moderation Process of the Tail-Risk Hedging Managers

The VIX Index and Volatility-Based Global Indexes and Trading Instruments - A Guide to Investment and Trading Features

During the past two decades, the Cboe Volatility Index (VIX® Index), a key measure of investor sentiment and 30-day future volatility expectations, has generated much investor attention because of its unique and powerful features. The introduction of VIX futures in 2004, VIX options in 2006, and other volatility-related trading instruments provided traders and investors access to exchange-traded vehicles for taking long and short exposures to expected S&P 500 Index volatility for a particular time frame. Certain VIX-related tradable products may provide benefits when used as tools for tail-risk hedging, diversification, risk management, or alpha generation. Gauges of expected stock market volatility for various regions include the VIX Index (United States), AXVI Index (Australia), VHSI Index (Hong Kong), NVIX Index (India) and VSTOXX Index (Europe). All five of these volatility indexes had negative correlations with their related stock indexes price movements, and all five volatility indexes rose more than 50% in 2008. Although the five volatility indexes are not investable, investors can explore VIX-based benchmark indexes that show the performance of hypothetical investment strategies using VIX futures or options. Before investing in volatility-related products, investors should closely study the pricing, roll cost, and volatility features of the tradable products and read the applicable prospectuses and risk disclosure statements.

Tail-Risk Hedging, Dividend Chasing, and Investment Constraints: The Use of Exchange-Traded Notes by Mutual Funds

Tail-Risk Hedging, Dividend Chasing, and Investment Constraints: The Use of Exchange-Traded Notes by Mutual Funds

Tail-risk hedging, dividend chasing, and investment constraints: The use of exchange-traded notes by mutual funds

Abstract Our study examines mutual fund demand for a newly designed security, exchange-traded notes (ETNs). We find strong evidence that mutual fund long positions in ETNs significantly underperform and that the motivations to hold ETNs lie outside of maximizing returns. Mutual funds hold ETNs to hedge tail risk and to gain access to higher dividend yields. Mutual funds have a strong preference for derivative-like ETNs although this preference is unrelated to contractual constraints. Finally, we show that skilled timing of ETN investments is limited to the short-sales market.

The VIX Futures Basis: Determinants and Implications

After the Chicago Board Option Exchange’s (CBOE) introduction of VIX futures contracts, and the subsequent introduction of exchange-traded products for volatility investing, investors have allocated non-trivial portions of their portfolios to volatility-linked investments. Since 2003, when significant changes were made to the VIX methodology, the CBOE has asserted that the VIX methodology provides a script for replicating volatility exposure using SPX options. The authors of this article find that, to the contrary, significant option market frictions, particularly among out-of-the-money put options, result in significant barriers to replicating this exposure. They connect option market frictions to changes in the VIX futures basis and find that market information from the most illiquid options is reflected in the VIX, but often not in VIX futures. Because investors frequently advance tail risk hedging as the main portfolio benefit of volatility exposure, the fact that out-of-the-money put option innovations drive the VIX futures basis suggests that, in practice, VIX futures do not provide the desired tail risk hedge.

Behavioral Perspectives on Tail-Risk Hedging

Various aspects of tail-risk hedging are explored from a behavioral perspective. We first demonstrate that a myopic approach to tail hedging that does not properly account for the value of the hedging in the full portfolio context can overlook its benefits. We also address the overpricing of deeply out-of-themoney puts in the context of a behavioral model and show that the skew can be rational and persistent within these models for a wide range of reasonable parameters. In addition, we show how in the presence of investors who prefer more skewness to less, negative expected return tail hedging can be perfectly rational, even in the presence of other investors for whom tail hedging is not optimal. Finally, we discuss how tail hedging overcomes time inconsistency in investor behavior and thus can be used as a precommitment device.

A Value Investing-Based Approach to Catastrophe Bonds and Tail Risk Hedging

This paper is a compilation of two articles that were written on the subject of catastrophe bond valuation (Part 1 of the paper) and tail risk hedging (Part 2 of the paper) from a value investing perspective. The paper presents a practical introduction to these topics that was written to the value-oriented readership of Marc Faber’s popular investment periodical, "The Gloom, Boom & Doom Report" in 2013 and 2014.

Tail-Risk Management for Retirement Investments

One of the insights of behavioral finance is the tendency for small investors to overreact to market swings. Even a well-structured portfolio may be vulnerable to panic selling in a downturn. The article explains how a policy of tail-risk hedging could deter such behavior by putting a floor on drops in the portfolio. Instead of maintaining an overly conservative stance and an unnecessarily low share of equities, investors could hedge their portfolios by relying on options, which have become a much more feasible tool for the small investor in recent years. The article discusses the relationship between the time to retirement and the need to hedge. Investors nearing retirement have to adopt a more defensive position or hedge explicitly, but younger investors can be more aggressive and buy options with lower strike prices.

The value of tail risk hedging in defined contribution plans: what does history tell us

AbstractHedging against tail events in equity markets has been forcefully advocated in the aftermath of recent global financial crisis. Whether this is beneficial to long horizon investors like employees enrolled in defined contribution (DC) plans, however, has been subject to criticism. We conduct historical simulation since 1928 to examine the effectiveness of active and passive tail risk hedging using out of money put options for hypothetical equity portfolios of DC plan participants with 20 years to retirement. Our findings show that the cost of tail hedging exceeds the benefits for a majority of the plan participants during the sample period. However, for a significant number of simulations, hedging result in superior outcomes relative to an unhedged position. Active tail hedging is more effective when employees confront several panic-driven periods characterized by short and sharp market swings in the equity markets over the investment horizon. Passive hedging, on the other hand, proves beneficial when they encounter an extremely rare event like the Great Depression as equity markets go into deep and prolonged decline.

Volatility of Volatility and Tail Risk Premiums

This paper reports on tail risk premiums in two tail risk hedging strategies: the S&P 500 puts and the VIX calls. As a new measure of tail risk, we suggest using a model-free, risk-neutral measure of the volatility of volatility implied by a cross section of the VIX options, which we call the VVIX index. The tail risk measured by the VVIX index has forecasting power for future tail risk hedge returns. Specifically, consistent with the literature on rare disasters, an increase in the VVIX index raises the current prices of tail risk hedges and thus lowers their subsequent returns over the next three to four weeks. Furthermore, we find that volatility of volatility risk and its associated risk premium both significantly contribute to the forecasting power of the VVIX index, and that the predictability largely results from the integrated volatility of volatility rather than volatility jumps.

Assessing Strategies in Tail-Risk Protection

Tail-risk hedging is designed to protect investors against tail-risk events, but like other forms of insurance, it involves material costs. Weighing the cost of a strategy—to the extent that it can be measured—against its ability to insure a portfolio from the consequences of the tail event can be challenging. Not all proposed hedges are obviously worth the cost.

Tail Hedging Strategies

This article introduces an algorithm for tail risk hedging and compares it to other existing methods. This algorithm adjusts the exposure level based on a measure of tail risk obtained by applying Extreme Value Theory (EVT) to estimate Conditional Value at Risk (CVaR). This method is applied to the SP additionally it can replace long/short equity hedge funds for investors who do not have access to alternative investments.

A Constant-Volatility Framework for Managing Tail Risk

Since Lehman Brothers collapsed in 2008, tail-risk hedging has become an increasingly important concern for investors. Traditional approaches, such as purchasing options or variance swaps as insurance, are often expensive, illiquid, and result in a substantial drag on performance. A more prudent, cost-effective way to maintain a constant risk exposure is to actively manage portfolio exposure according to the prevailing volatility level within underlying assets. The authors implement a robust methodology based on Dybvig’s payoff distribution model to target a constant level of volatility and normalize monthly returns. This approach to portfolio and risk management can help investors obtain their desired risk exposures over both short and longer time frames, reduce exposure to tail risk, and in general increase portfolios’ risk-adjusted performance. <b>TOPICS:</b>Tail risks, volatility measures, financial crises and financial market history