Parametric Risk Advisors Tail Risk Strategies 2012.Web .CA 1

7/31/2019 Parametric Risk Advisors Tail Risk Strategies 2012.Web .CA 1

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TAIL RISK STRATEGIESOptions Strategies: An Alternativeto Expensive Complex Tactics

Volatile nancial markets can create potential problems for investors atheir advisors. While many expenses are generally xed, assets designate

to fund expenses may increase or decrease in value. In a worst ca

scenario, managers may have to liquidate assets at potentially distresse

levels to meet these obligations.

In the current environment, many managers have been forced to sell wh

they can, rather than what they want, resulting in skewed allocations

which less-liquid asset classes have become larger components

portfolios.

Parametric

1918 Eighth AvenueSuite 3100Seattle, WA 98101T 206 694 5575F 206 694 5581www.parametricportfolio.com

RESEARCH BRIEF

March 2012

Copyright 2012 Parametric Portfolio Associates, Inc. All rights reserved. For informational purposes only; not an offer to buy or sell securities.


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Parametric White Paper / March 2012 Tail Risk Strategies / Options Strategies: An Alternative to Expensive Complex Tactics

Overall market events since 2008 have given rise to a heightened awareness of textreme downside risk of all asset classes. These downside risks, also known as tail-risor black swan events are generally rare occurrences which result in large movementsthe market. The concept of tail-risk or black swan is based on the notion that mark

returns are distributed as a Bell Curve, where most of the market returns are centerabout an average return and the less-frequent occurrences of large positive and negatreturns are at the tails of the return distribution:

FIGURE 1: ACTUAL AND IMPLIED DISTRIBUTION OF S&P 500 INDEX RETURNS, 1998 - 2011

Source: Parametric Risk Advisors and Bloomberg.

This situation has recently led many advisors to have their clients consider various tarisk hedging strategies.

TYPICAL TAIL-RISK HEDGING

The concept of tail-risk hedging is relatively straightforward; however, choosing the rigimplementation strategy to best mitigate tail-risk is less straightforward. The potentcauses of a tail-risk event are numerous. As a result, trying to hedge against a singcause is difcult. In our opinion, it is best to dene the potential consequences of a tarisk event and then implement a strategy to mitigate those. In this report, we will limit tdiscussion to diversied equity portfolios, which largely narrows the available mitigatitools to primarily equity derivatives, such as options.

In our experience, the most commonly proposed strategy for hedging tail-risk is

systematic purchase of S&P 500 Index put options. Put options can generally be thougof as a form of insurance. The buyer of the option receives the difference between tstrike price of the option and the price of the S&P 500 at maturity (as determined the exchange). There is no optimal strike price but most programs utilize strikes whare generally ~25% out-of-the-money (meaning the strikes are priced~25% lower ththe market level at the time of purchase).


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For example, a systematic purchase of equity options can be a program of purchasieither short-dated (e.g., three months) or longer-dated (e.g., 12 months) S&P 500 poptions. One benet of utilizing shorter dated options is the frequency of re-striking tprotection level to keep pace with market rallies (i.e., rolling the options); however, t

downside is the increased cost of purchasing new options every three months.

A longer-dated program may initially seem less expensive per diem since the invesis purchasing new options less frequently; however, as the market rallies, the prograrequires ongoing maintenance. The long dated option can lose value quickly in tscenario and needs to be rolled into a higher strike option to maintain protectiohowever, the result is increased total cost.

An alternative to S&P 500 Index put options are CBOE Volatility Index (VIX) optioand S&P 500 variance swaps, which can be utilized to hedge equity tail-risk. The theobehind these hedges is that the implied volatility of equity options increases durimarket declines. Both VIX call options and long S&P 500 variance swaps are genemeasures of the implied volatility of options and should increase in value during mark

declines, assuming correlation to the Index remains constant.

A VIX call option is similar to an S&P 500 put option; in exchange for an upfront premiuthe option buyer seeks to benet from a payout equal to the difference of the VIX leat maturity and the strike price. However, hedging S&P 500 Index exposure with instrument linked to S&P 500 implied volatility introduces basis risk. This effectiveintroduces another variable, correlation. We believe an effective hedge using VIX optiorequires the S&P 500 Index (SPX) and VIX to be negatively correlated, otherwise texact market decline the investor has hoped to mitigate might occur without the Vincreasing. Figure 2 illustrates the historical correlation.

As seen in Figure 2, while the negative correlation has been consistent, there have betimes when this correlation breaks down and a hedging strategy utilizing VIX optiowould not have worked as hoped. Specically, during periods around the internet bubbin 2002 and the subprime crisis in 2008/2009, the negative correlation disappeareresulting in the reduced effectiveness of the VIX hedge strategy.

S&P 500 variance swaps are more like a futures contract, rather than an option.variance swap is basically a long or short position on the direction of volatility. Assumthe investor goes long variance, they potentially benet if the nal VIX level is highthan the swap strike; however, unlike an option, in this example the investor owes tcounterparty should the VIX level be lower than the VIX strike at maturity. In additto the introduction of basis risk between the S&P 500 Index and S&P 500 varianwe believe a variance swap is a less-predictable hedge because the ultimate downsexposure is not known until maturity (unlike an index put option, where the downside

limited to the premium paid).

A tail-risk event is, by denition, a rare event. As a result, a true tail-risk hedging strateshould be a long-term commitment. Opportunistic hedging in hopes of protecting againthe occurrence of an actual tail-risk event is akin to the odds of drawing the winninumbers for Powerball. Effective hedging is not luck. Our own experience suggesthat investors generally commence a hedging strategy with a long-term intentiohowever, after several months of spending premium costs with no return, a discussiof effectiveness may result. Many times this results in an investors early terminationsuspension of the program, often at exactly the wrong time.


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Complexities aside, the upfront cost of these strategies, especially in higher-volatienvironments, typically results in no action. Upon review, most investors may realthat they dont really need expensive tail-risk protection, but rather a plan that ain normalizing their cash ows between times of market balance and times of mark

stress.

FIGURE 2: CORRELATION BETWEEN S&P 500 AND VIX INDICES (JAN. 21, 2000 - SEPT. 30, 20

Source: Parametric Risk Advisors and Bloomberg.

CALL WRITING

Parametric Risk Advisors (PRA) implements an alternative to traditional tail-risk hedgistrategies which, over the long-term, seeks to offer cash ow enhancement duriperiods of portfolio stress, without disrupting typical portfolio management. Insteadpurchasing options, PRA utilizes an index option-overlay program designed to reshathe risk/return prole of equity portfolios as follows:

Systematic option overlay programs can potentially generate extra income to hinvestors achieve their cash ow requirements.

Call writing seeks performance in moderately up, at or down markets, potentiaproviding additional cash ow, which reduces the need for depressed asset sal

Active risk management, a critical factor in any successful call writing progra

can allow for corresponding potential growth in the underlying investments durrising markets.

Call writing can be implemented in an operationally friendly manner.

While many industry, consultant and academic pieces have been written on the beneof systematic call writing over the last several years, the goal here is to promote furthdiscussion by providing some examples and practical applications of an option-overprogram strategy.

AVERAGE -74.32%

STD. DEV. 25.60%

MINIMUM -99.26%

MAXIMUM 50.09%


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VALUE PROPOSITION

Our research shows that an equity option volatility disparity exists and is persisteSimply put, there is a supply vs. demand imbalance for equity options. Investors genera

buy call options to speculate on the potential appreciation of a stock and/or buy poptions for protection from a potential decline. The sellers of those options, often banbroker/dealers and institutional traders, incur general risks and costs to hedge optiopositions thus, in our view, effectively increasing the market prices above the theoretiprices. The risk of hedging is an unknown, so a slight risk premium generally exists

This risk premium is illustrated in the market when comparing implied and realizvolatility. Implied volatility is generally the market expectation of the future volatiof the underlying stock, as observed via the option market. The VIX is an index thmeasures the implied volatility of the S&P 500. Realized volatility is the actual realizvolatility of the underlying stock. As seen in Figure 3:

Historically, the S&P 500s implied volatility generally has exceeded its realiz

volatility.

Over the last ve years, the average ratio of SPX implied call option volatilitySPX realized volati lity was approximately 119.5%.

FIGURE 3: IMPLIED VOLATILITY VS. HISTORICAL VOLATILITY FOR THE S&P 500 INDEX*

Source: Bloomberg.

A holder of equity beta via a diversied equity portfolio or an index may be uniquepositioned to systematically sell call options for more than their theoretical value. Insense, these investors are natural sellers since they are already hedged; that is, thare long the underlying asset or beta and do not need to incur the costs associated whedging. If the value of the underlying asset increases, resulting in an exercise of option, we expect that the investors underlying portfolio should increase by at least much as the exercise value. Obviously, in any non-covered transaction, the client incutracking risk between the underlying option and the underlying portfolio.

*This data is for illustrative purposes only. Eachstock/index will have a different historical volatilityand observed, implied volatility set.


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We have seen how a systematic program of selling call options against an equity portfomay improve total return and reduce volatility. The BXM** and BXY Indices replicatesystematic program of selling S&P 500 calls against a long position in the S&P 50Over the long term, the BXM and BXY have historically outperformed the S&P 500 a

had lower volatility:

TABLE 1:

JUNE 1, 1988 - SEPT. 30, 2011

ANNUALIZEDRETURN (%)

VOLATILITY(%)

S&P 500 (Total Return)

SPTR Index

8.78 18.09

BXM Index 8.95 12.76

BXY Index 9.98 14.51

Source: S&P 500 / BXM/ BXY Returns: Bloomberg.

While the BXM and BXY may serve as benchmarks that make the case, in our opinthere are signicant drawbacks when considering an actual program that attempts replicate the BXM and/or BXY. The at-the-money options sold in a BXM strategy ato reduce equity upside potential to zero (not factoring in any alpha from the underlyiportfolio). The BXY strategy utilizes 2% out-of-the-money options, which provide a more upside potential but do not reect changes in equity option volatility.

It is important that an overlay strategy (long equity portfolio plus systematically sellicall options) have a consistent long-term risk/return target. In our opinion, it is difcult analyze any strategy, in any asset class, without knowing the risk/return parameters.

In addition, its important for investors to realize that the same relationship that makes cwriting effective makes put buying unattractive over time. For example, put buyers agenerally paying a higher-than-theoretical price for their options due to the implied realized volatility premium.

RISK-BASED OPTION SELECTION: A MORE SENSIBLE APPROACH

Our research shows that a rules-based, actively managed, risk-managed overlay stratein which option strikes are selected based on a measure of risk and return, is better thone which is xed in nature (i.e., BXM, BXY). We believe that an appropriate strateeffectively indexes the strike selection based on volatility; as volatility rises, so sho

strikes; as volatility falls, so should strikes.Generally, in our view, an actively managed call writing strategy may generate positalpha under four different stock market scenarios:

i. Moderately rising markets

ii. Stable or at markets

iii. Moderately down trending markets

iv. Sharp market declines

**The CBOE S&P 500 BuyWrite Index (BXM)is a benchmark index designed to track theperformance of a hypothetical buy-write strategyon the S&P 500 Index.

The CBOE S&P 500 2% OTM BuyWrite Index(BXY) uses out-of-the-money S&P 500 Index(SPX) call options, rather than at-the-money SPXcall options.

The BXM Index consists of a loposition in the S&P 500 combinwith selling one-month call optiowith a near-the-money strike.

The BXY Index is similar to BXM Index, but a 2% out-of-thmoney call is sold.


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Active call writing strategies do not provide protection from downside risk beyond taggregate value of the option premium received. Experience tells us that the strateshould produce positive alpha in scenarios (iii) and (iv) above; however, the total retuof the portfolio during that period would likely be down. We believe an overlay strate

should provide investors with cash ow during the periods they may need it most, becaumany of the calls written in scenarios (iii) and (iv) would most likely expire worthless.

In strongly rising equity markets we believe a call writing strategy should generaunderperform the underlying passive index. However, given the short-term nature of toptions sold and the active rules-based management utilized, in our view the portfovalue should not be capped; rather in very strong equity markets the overall portfolio retumay potentially trail the underlying index slightly.

Below is a hypothetical simulation of an actively managed S&P 500 call writing prograversus the S&P 500.

FIGURE 4: TOTAL RETURN IMPLEMENTATION*(DIVIDENDS AND OPTION PREMIUMS MAINTAINED IN ACCOUNT)

*This data is for informational and illustrativepurposes only. It should not be consideredinvestment advice, a recommendation to buy orsell a particular security or to adopt any investmentstrategy. The information presented is based, inpart, on certain hypothetical assumptions, theexperience of PRA, and the application of anoption overlay strategy process in a back-testingenvironment with the benefit of hindsight. Thehypothetical information presented does notrepresent the results or investment experiencethat any particular investor actually attained. Actualperformance results will differ, and may differsubstantially, from the hypothetical performancepresented above. Each stock or index will have adifferent historical volatility and observed, impliedvolatility set. It is not possible invest directly in anIndex. Past performance is no guarantee of futureresults. Please refer to the Appendix, beginningon page 13, for a description of the assumptionsused in the above Chart and additional importantinformation and disclosure.

INDEX LEVEL AT END OF 1 YEAR LONG INDEX

$ INDEX LEVEL % CHANGE TOTALRETURN

$1,524.80 Up 20.00% 22.14%

$1,461.27 Up 15.00% 17.14%

$1,397.74 Up 10.00% 12.14%

$1,334.20 Up 5.00% 7.14%

$1,270.67 (Initial Price) 2.14%

$1,207.14 Down 5.00% (2.86%)

$1,143.60 Down 10.00% (7.86%)

$1,080.07 Down 15.00% (12.86%)

$1,016.54 Down 20.00% (17.86%)

SIMULATION

TOTALRETURN

19.26%

15.78%

12.16%

8.39%

4.47%

0.40%

(3.80%)

(8.14%)

(12.62%)

Source: PRA.


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The previous chart illustrates the simulated performance of a hypothetical overprogram versus the underlying index. In this simulation, the hypothetical overlay prograoutperforms (and generates excess free cash ow) in down, at and moderately markets. Equally important is that in a signicant up market, the simulations hypotheti

program continues to appreciate, though slightly slower than the underlying index, aavoids the capped (hockey stick) payoff traditionally associated with the sale of covercalls. Below, we discuss the risk management component of the hypothetical program thseeks to avoid the capped nature of traditional call writing programs.

RISK MANAGEMENT

An overlay program seeks to transform a theoretically designed framework into actionable, risk-managed investment strategy. While the volatility discrepancy is observaand persistent, the sale of options results in an asymmetric liability. Selling (typically) o12 options per year (the BXM strategy) may not result in sufcient observations to expl

the inefciency and may unintentionally introduce concentration (date, time, notiospecic) risk.

The lack of active risk management further exposes the portfolio to potentially big lossthat may affect the long-term goals of the portfolio.

PRAs risk management incorporates several key steps:

Overlay Strategy

We use multiple strikes and maturities to maximize the observation set as opposed common passive strategies that generally expose the portfolio to a single path of only observations per year:

Create a laddered portfolio of options with multiple strikes and maturities seekto diversify the time-/date-/price-specic risk of selling call options.

We use sale of short-dated options only to minimize and seek to diversify time- and evespecific risks as opposed to common passive strategies that generally expose the portfoto widely divulged expiry and sale (roll) date:

Seek to reduce the sold call option risk by limiting the time to expiration astaggering expiries across many dates.

Ongoing risk management

Early profit capture

When the opportunity arises we attempt to take advantage and repurchase shoptions at a fraction of the original price resulting from index movement, chanin volatility or excessive time decay.

As an overlay, or alpha, strategy, we believe it is prudent to capture protsand when available (which otherwise could turn into losses) seeking to transfopotential prot with an associated open-ended liability into certain prot with associated ongoing liability.


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Loss mitigation

If the underlying index appreciates from the initial index level whereby the risk reward exposure to the portfolio, in our opinion, becomes unfavorable, we seek

mitigate the risk by attempting to repurchase open options and reallocating totime decay state by rolling option up and out.

For us, the greatest value-added proposition of an option overlay strategy is the objectand systematic application of loss mitigation. The volatility inefficiency that ultimatgenerates alpha is independent of the absolute direction of the market (or delta). Eventhe volatility imbalance is in the sellers favor, in any period the market may move againthe position. In our opinion, it is prudent to quickly mitigate the small losses (that can grasymmetrically large) and reallocate to options which meet the initial risk/return targeThis loss mitigation technique is why we believe an option overlay strategy program mhave ongoing upside participation in appreciating markets as opposed to the traditiohockey stick payoff associated with passive covered call strategies.

Using these rules-based risk management guidelines allows PRA to adjust an optoverlay strategy program to reflect the desired risk/return guidelines:

Hypothetical Examples*

FIGURE 5: EXAMPLE 1: EARLY PROFIT CAPTURE

If the option loses a significant amount of value due to index movement, change volatility or excessive time decay, PRA seeks to take advantage and attempt to repurcha

previously sold call options at a fraction of the original sale price.

*Source (Figures 5 - 7): PRA.Hypothetical examples and hypothetical index path.There is no guarantee that an actual index will havesimilar performance as seen in the above examplesor that PRA will be able to achieve the results

illustrated in the hypothetical examples.


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0

FIGURE 6: EXAMPLE 2: INDEX REMAINS RELATIVELY FLAT

If the underlying index stays within an expected range; the options value decays eaday. If the index remains below the call strike, then PRA will either let it expire worthleor seek to buy it back at a fraction of its original price.

FIGURE 7: EXAMPLE 3: INDEX APPRECIATES

If the underlying index appreciates from the initial index level and PRA believes the risk

reward exposure of the option becomes unfavorable, PRA may seek to mitigate the riskrepurchasing the sold call option (generally for a loss) and sell a new, higher strike optby rolling option up and out (up to a higher strike price and out to a longer maturity) .


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CONCLUSION

So how is an option overlay strategy utilized in the real world? For investors, a managoption overlay program may be used as an alternative to a traditional tail-risk hedgi

program. When properly implemented, the strategy may provide signicant cash generation in down markets (when excess cash may be needed most), while maintainupside exposure in rising markets.

In a typical scenario, a potential client approaches PRA to discuss risk managemehedging strategies or tail-risk strategies. After a thorough review of the alternativincluding purchasing puts, engaging in collars, VIX options and variance swaps, mopotential clients may conclude that the uncertain outcome, costs and/or basis risk are tmuch to overcome. We nd the one strategy that does merit further discussion tends be a call writing strategy.

For example, in 2007 we were approached about a hedging strategy. After signicaanalysis, the conclusion reached was that the results of a put purchasing strategy (with

without call writing) would not, over time, offset the signicant premium or opportunity cospent to implement the program. There was agreement that put options were appropriaif the investor had a discrete cash ow to hedge, but, for them, in this case the stratewas not appropriate as a portfolio strategy.

Instead, they chose to engage in a call writing strategy as a simple alternative to heprotect cash ow. During the 2008/2009 nancial crisis, the strategy implementprovided strong performance, and delivered cash ow that allowed them to limit its saof distressed securities.

Then, during the period from March 2009 through April 2011, the underlying markincreased approximately 100% as measured by the S&P 500 Index. The call writiprogram underperformed, but the active risk management guidelines helped limit t

underperformance.Over the last six months ending 9/30/2011, implementing call writing strategies haonce again provided cash ow for many investors while equity markets have declined.

The implementation of a call writing program is extremely straightforward. We believe,most cases, it can be accomplished without any disruption or restrictions related to tunderlying managers and little or no administrative oversight from the Foundation ofc

A quick overview of the option overlay programs general implementation steps fortypical investor:

Investor designates the beta component of portfolio that will be covered by tprogram.

Investor opens a brokerage account with their choice of broker-dealer rm.

PRA begins implementing call option selling; option positions settle in brokeraaccount.

Investors custodian issues escrow receipts to cover the positions at the brokdealer; all equity assets remain at custodian.

Investor maintains underlying equity portfolio alpha plus any potential alpgenerated from call writing overlay.


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In our view, this strategy is an efcient method for monetizing embedded volatility exposuCall writing alters the risk/return prole of the underlying portfolio, generally in line winvestor goals and objectives:

Strategy generally underperforms in strongly rising markets Strategy generally outperforms in moderately rising markets

Strategy generally outperforms in at markets

Strategy generally outperforms in down markets

PRAs option overlay strategy seeks to generate excess cash ow when portfolio most stressed, mitigating some of the need to sell securities at distressed levels to fuoperations. The strategy generally requires excess cash ow when portfolio is leastressed, when portfolio gains are more likely to be realized.

PRAs strategy may also allow for a reallocation of the risk budget from the underlyibeta to other investments, due to the expected decrease in the standard deviation returns.


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APPENDIX

Below are the assumptions applied in the hypothetical simulations and examples noted

Simulated Index Path

Terminal index levels are arbitrary and chosen for illustrative purposes only.

12-month simulation period (path is calculated on a bimonthly basis).

Simulation volatility = 20.80% and is based upon historical trend as determined Parametric Risk Advisors (Bloomberg observations).

Bimonthly index levels are set on a straight line basis to achieve the terminal indlevel.

Dividend amount is held constant.

Total Return: (Ending index level + cumulative dividends) / initial index level.

Hypothetical Returns

25.00% call option is written on available index units at beginning of each two-monperiod.

Option volatility = 26.00% and is based upon relationship between near-the-monimplied volatility and historical volatility as determined by Parametric Risk Adviso(Bloomberg observations. Not based off implied forward volatility).

Historical volatility is assumed to be 82.00% of option volatility.

Two-month LIBOR on simulation date is used to price options.

Dividend is based off historical dividends as of simulation date and assumes growth.

All option premiums and dividends are held accruing no interest.Call premium received is equal to Black Scholes European style option with simulatdate two-month LIBOR, implied volatility (as described above) and simulation daconstant dividend amount.

Call option expected liability is equal to Black Scholes European style option wsimulation date two-month LIBOR, simulation volatility (as described above) and adjusted dividend yield to result in forward price equal to simulation assumed grow

All options are cash settled.

If option settlement value exceeds free cash, index units are sold to make up differen

Simulation assumes nine trades per year.

Simulation option brokerage commission is $2.00 per contract.

Simulation is net of management fees and transactions costs.

Transactions costs will vary based on both the size of the account and the brokedealer. Assumed Eaton Vance (EV) Management fee is 0.60% per year. Feededucted from dividends and option premiums. If cash is insufcient, index units asold to fund fees. Total Return:[(Ending cash balance resulting from option sales (leoptions commissions as indicated and EV fees) + (Ending index level x percentageinitial index units still owned) + cumulative dividends received] / the initial index le


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About Parametric

Parametric is an industry-leading provider of structured portfolio management, headquartered in Seat

Washington. Parametric and its afliate, Parametric Risk Advisors, offer a variety of structured portfolio solutio

including customized core equity portfolios (U.S., Non-U.S., global), options strategies, and overlay portf

management. Parametric is a majority-owned subsidiary of Eaton Vance (ticker: EV).

DisclosureThis information is intended solely to report on investment strategies and opportunities identied by Parame

Portfolio Associates. Opinions and estimates offered constitute our judgment and are subject to change with

notice, as are statements of nancial market trends, which are based on current market conditions. We belie

the information provided here is reliable, but do not warrant its accuracy or completeness. This material is

intended as an offer or solicitation for the purchase or sale of any nancial instrument. Past performance do

not predict future results.

The views and strategies described may not be suitable for all investors. Parametric does not provide legal,

and/or accounting advice. Clients should consult with their own tax or legal advisor, who is familiar with

specics of their situation, prior to entering into any transaction or strategy described here.

The data and model information presented is based, in part, on hypothetical assumptions. No representation

warranty is made as to the reasonableness of the assumptions made or that all of the assumptions used

achieving the returns have been stated or fully considered. Hypothetical results have many limitations and

representation is made that any account will or is likely to prot similar to those shown. Actual performan

results will differ and may differ substantially from this hypothetical performance. Changes in the assumptio

may have a material impact on the hypothetical returns presented. Performance for back-tested data does

represent the results of actual trading, but was achieved by means of retroactive application of a model design

with the benet of hindsight.

Options are not suitable for all investors. Please ensure that you have read and understood the current opti

risk disclosure document before entering into any options transactions. In addition, please ensure that you h

consulted with your own tax, legal and nancial advisors prior to contemplating any derivative transactions. T

options risk disclosure document can be accessed at the following web address: http://optionsclearing.co

publications/risks/download.jsp.

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Parametric Risk Advisors Tail Risk Strategies 2012.Web .CA 1