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8/6/2019 Tail Risk Hedging May2010
1/21
Pleaseseeimportantdisclosuresattheendofthisdocument.
DeutscheBankPensionStrategies&SolutionsisapartofGlobalMarketsInstitutionalClientGroup
Tail Risk Hedging: A Roadmap for Asset Owners
DeutscheBankPensionStrategies&Solutions
May2010
Wetookrisks.Weknewwetookthem.
Thingshavecomeoutagainstus.
Wehavenocauseforcomplaint.
RobertFrost
"Itisoftensaidthat[one]iswisewhocanseethingscoming.
Perhapsthewiseoneistheonewhoknows
thathecannotseethingsfaraway."
NassimTaleb
8/6/2019 Tail Risk Hedging May2010
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Tail Risk Hedging: A Roadmap for Asset Owners
1
Mounting Tail Risk Concerns
Followingthetraumaticeventsofthe lasttwoyears,riskand itsmanagementhavebecomethe
mostvisiblesubjectwithintheassetownerworld.Aspartofthemanagementoftherisk,tailrisk
hedginghastakencenterstage.
Thispaperaims toprovideaclear,stepbystepguide to theprocessofhedging tail riskacross
manyasset types.Wehopethat it isable toprovideusefulexamples,commonsensesolutions,
andadvantage/disadvantageanalysisofvariousapproaches.Wehavemadeeveryefforttomake
itscontentclear,concise,anduseful.AlthoughDeutscheBankGlobalMarketsdoesnotact ina
fiduciarycapacityandthisdocumentisprovidedforinformationalpurposesonly,wehopethatit
canserveasapositivesteptowardhelpingourclientsmakeinformeddecisions.
Pleasedonothesitatetocontactusifyouhavequestions.
KenAkoundiPensionStrategies&Solutions
GlobalMarketsInstitutionalClientGroup
Phone:2122505437
Email:[email protected]
JohnHaughPensionStrategies&Solutions
GlobalMarketsInstitutionalClientGroup
Phone:2122508970
Email:[email protected]
Defining Tail Risk
Tail risk is technicallya riskofaportfoliovaluemoveofat least three standarddeviations (3)
fromthemeanandismoreprobable(frequent)thananticipatedbyanormaldistribution.
However, the recent surge of interest in this topic has not remained limited to this precise
definition,butinsteadhasdriventheuseoftheterminologytorefertothepossibilityofgeneric
rare events. Since every dataset can be roughly characterized by a distribution (e.g., Normal,
Poisson) that is in turn characterizedbymean, standarddeviation,etc., identifying the specific
relevantdatasetisimportant.
Theemergentnebulousmeaningofthetermtailriskisnotentirelyinvalid,butneedbebetter
framed. Inthecontextofthisdocument,afunctionalmeaning isused: inessence,tailrisk isthe
riskthatalargemoveinaportfolioisgreaterthanwhatisimpliedbytraditionalriskmanagementtheories(withoutimplyinganexpectedseverityoftheevent,suchas3 or6).
With this framework,we thereforeuse the term tail riskhedging to refer to the creationof
positionswithinaportfoliothatarecreatedtoprotectagainstdownwardmarketmoves.
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Tail Risk Hedging: A Roadmap for Asset Owners
2
Hedge Selection Process
Withthewidearrayoftailriskhedgesavailable,itisintegraltodevelopasystematicstrategyfor
selectingproducts and building a hedgeportfolio. There are three fundamental steps, each of
which presents a series of questions that have been formulated to help an asset ownersuccessfullynavigatethetailriskhedgingdecisionprocess.
1. Analysis:Beginswithareviewofportfolio factors/exposuresandadeterminationof the
desiredportfoliobehaviorandconstraints towhichahedgewouldbe subject.This step
includesdiscussionofhedgingparameterssuchasestimatedeventprobabilityandasset
classaswellassuitabilityandcosttoleranceanalysis.
o Whatarewehedging?Page3
o Activehedgingordiversification?Page4
o Whathedginginstrumentsmaybeappropriate?Page5
2. Synthesis: Involves hedge selection and bespoke solution construction, pretrade
monitoring,legalandoperationalreview,costanalysis,andexecution.
o Whatarethecostsofhedging?Page7
3. Monitoring:Monitoringincludesquantifiablereviewoftradeimpactandofthesuitability
of choosing to monetize or unwind instead of continuing to hold the hedge. The
supervision levelandmonitoringfrequencyrequiredwillalsoaffect instrumentselection.
Forexample, ifdailymonitoring isnecessary, then illiquidbespokesolutionsmaynotbe
ideal.
o Whataremymonitoringconstraints?Page8
For convenience,wehave created aTailRiskDecision Table (Table 3),which canbe foundon
page16*.
*SomehedgetypesmentionedinTable3arenotexplicitlydiscussedelsewhereinthepaper.Pleasecontactusto
discuss.
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Tail Risk Hedging: A Roadmap for Asset Owners
3
What are we hedging?
Asset Hedging
Withaworkingdefinitionof tail risk inhand,anassetownermustdecideon thedegreeof
hedging desired. Is the hedge to be placed at the single instrument level (e.g., toomuch
Microsoftexposure), theme/sector level (e.g., toomuchexposure to tech),asset class level
(e.g., toomuch Beta to S&P 500), or portfolio level (e.g., toomuch exposure to equities)?
Usuallythis isthehardestquestion,but itsanswerbeginswithasimple lookattheportfolio
anditsmakeup.Itisassumedthatassetownershaveagoodunderstandingoftherisksintheir
portfolioeitherquantitativelywhichispreferredorqualitatively,whichismorecommonly
the case.For reference, averageDefinedBenefitportfolio allocations are roughly similar to
Table1below.
If the choice is made to hedge at the
assetlevel,whichisusuallythecase,then
the
first
decision
to
be
made
is
which
subset of the portfolio needs hedging;
the conclusion tends to be equities,
specifically S&P 500 equities because
they typically represent the largest
allocationwithin the portfolio and have
beenhistoricallyoneofthemostvolatile
andmosteasilyhedgible.Otherportfolio
subsets being considered by asset owners tobe hedge candidates include EAFE portfolios
(whichruntheriskofUSDrunup),inflation(whichimpactsbothfixedincomeandliabilities),
andsomerealassets(whichcouldbesusceptibletorealestatecollapse).
Liability Hedging
Amore complete analysis of hedging tail risks expands the assetonly paradigm to include
liabilities.Forexample,adeflationaryenvironmentiscripplingtopensionplansasdecreasing
ratesincreasethevalue(andcost)ofliabilities.Thiscanhaveatremendousnegativeeffecton
plansolvency,contributionrequirements,andfinancialreporting.Additionally,someinvestor
types,suchaspublicpensionsandendowments,oftenhave liabilitiestiedto inflation.These
typesofrisksshouldbe identifiedandanalyzedandappropriatehedgingsolutionsshouldbe
considered.
Europe,Australasia,FarEast
Table 1: Sample Defined Benefit Plan Allocation
Asset Class Target
Domestic Equity 40%International Equity 10%
Domestic Fixed Income 30%
International Fixed Income 2%
Private Markets (includes Hedge Funds) 10%
Real Assets (TIPS, Commodities, etc.) 5%
Cash 3%
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Tail Risk Hedging: A Roadmap for Asset Owners
4
Active Hedging or Diversification?Withatargetportfoliosubsetinmind,
the asset owner must now decide
whethertopursueactivehedgingortodiversifyallocation inordertobroadly
decreaseportfolio risk. In the context
ofthispaper,activehedgingisdefined
as the act of adding positions that
neutralizespecificrisktypeswithinthe
portfolio, and diversification is an
income investment that lowers
portfolio riskdue to lowercorrelation
between asset classes. This decision
will
hinge
on
the
firms
constraints,
assetallocationguidelines(suchasthe
preexistence of a commodity
allocation), legislative or corporate
governance issues (for some plans,
derivativesareprohibited),liquidityofthehedgemarket(equitiesaregenerallymoreliquidthan
corporatecredit),andexpectedseverityoftailevent(e.g.3 or5 event).
Forexample, if theportfoliodoesnot
yet include commodity exposure, a
straightforwardmeanstodiversifythe
portfolio isbyeitheraddingapassive
commodity allocation via an index
such as Deutsche Banks flagship
commodityindexDBC,orviaanactive
managedfuturesallocationsuchasthe
DB MATRIX index. Historically,
commodity indices have had a low
correlation to the portfolio and
thereforerepresentagooddiversifier.
Managed commodity futures have
exhibited a negative correlation to equities and naturally increased diversification. In Table 2above, the correlationbetweenmanaged commodity futures andother asset classeshasbeen
showntobezerotonegative.
Theassetcorrelationmatrixshown inTable2wasconstructedusingBloombergmonthendclosingprices forthe
period duringwhich consistent data is available for each instrument:March 2006April 2010. The correlation of
instrumentswithdataextendingearlierholdroughlyconsistenttothecorrelationsinthetable.Whereapplicable,the
previousdaysclosingpricewasusedonholidays forwhichdatawasnotavailable, inorderto facilitatecorrelation
calculations.
USBonds(AGG)
Co
mmoditiesIndex
(DBC)
USR
ealEstate(VNQ)
Eur
ope,Australasia,
FarEast(EFA)
USL
argeCapStocks
(VV)
Inflation-protected
Treasuries(TIP)
Volatility(VIX)
ManagedCommodity
Fu
tures(DBMatrix)
US Bonds (AGG) 0.07 0 .31 0 .38 0 .27 0 .76 -0.28 0 .00
Commodities Index
(DBC)0.07 0.34 0 .55 0 .49 0 .45 -0.27 -0.02
US Real Es tate (VNQ) 0.31 0 .34 0.77 0 .84 0 .27 -0.47 -0.33
Europe, Australasia, Far
East (EFA)0.38 0 .55 0 .77 0.93 0 .39 -0.63 -0.15
US Large Cap Stocks
(VV)0.27 0 .49 0 .84 0 .93 0.34 -0.65 -0.25
Inflation-protected
Treasuries (TIP) 0.76 0 .45 0 .27 0 .39 0 .34 -0.26 -0.11
Volatility (VIX) -0 .28 -0 .27 -0 .47 -0 .63 -0 .65 -0 .26 0 .00
Managed Commodity
Futures (DBMatrix)0.00 -0.02 -0.33 -0.15 -0.25 -0.11 0.00
Table 2: Correlation Matrix
Chart 1: Equity/Volatility Relationship
0
10
20
30
40
50
60
70
80
1/30
/200
4
5/30
/200
4
9/30
/200
4
1/30
/200
5
5/30
/200
5
9/30
/200
5
1/30
/200
6
5/30
/200
6
9/30
/200
6
1/30
/200
7
5/30
/200
7
9/30
/200
7
1/30
/200
8
5/30
/200
8
9/30
/200
8
1/30
/200
9
5/30
/200
9
9/30
/200
9
1/30
/201
0
EquityPerformance(Index:VV
)
0
10
20
30
40
50
60
70
80
90
Volatility(Index:VIX)
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Tail Risk Hedging: A Roadmap for Asset Owners
5
Although diversification is a valuable portfolio management tool, hedges may not hold their
characteristic correlation profiles under extreme market conditions. In order to hedge these
extremetailevents,anassetownercanchoose toactivelyhedge theportfolio.Forexample,an
assetownercanpurchaseprotectionagainstvolatilityspikes,whichhavefrequentlyoccurred in
conjunction with declining equity markets (see Chart 1
). At the trough of the 20082009downturn,theVIX index,ameasureofS&P500 indexshorttermvolatility,peakedat80.Atthe
timeofthiswriting,theVIXisinthelow30s,withacorrelationtoUSlargecapequitiesof0.65,
ascanbeseen inTable2.Note that this tablealsoshows that theVIXhasexhibitedhistorically
strongnegativeorlowcorrelationtotheotherassetclasses.
AlthoughdirectinvestmentsintheVIXaregenerallyexpensiveorfraughtwithbasis,theredoexist
many efficient methods for protecting against volatility spikes. These methods are addressed
furtherintheHedgeExamplessectiononpage11.
What hedging instruments may be appropriate?
Hedgevehicleselection isdependentonmany factors, themost importantofwhich iswhether
the firm isamanagerofmanagers,**orhas inhousehedging/overlay/trading rights,which in
legalparlanceisreferredtoasanInHouseAssetManagerorINHAM.
IftheassetownerisnotanINHAM,thendirecthedginginstrumentsmaynotbepermissibleand
allhedgingoroverlaysshouldbeperformedviaQualifiedPlanAssetManagers(QPAM),subjectto
anRFPprocess.
INHAM/QPAM
issues
notwithstanding,
the
selection
of
a
hedging
vehicle
depends
on
several
factors,listedbelow.
Are derivatives allowed in the portfolio?
Many plan sponsors currently do not directly trade derivatives in their portfolio, due to
portfolioguidelinesand/ortheindividualstatelawsthatgovernpublicplans.
Recently,asmarketshavegenerallybecomemoresophisticatedandliquid,pensionsandtheir
consultantshavebeguntoconsiderandadvocateforderivativesintheirportfolios.Thedesire
togainaccess tosomeassetclassesviaderivativeshasaidedacceptanceofderivatives,but
onlytoacertaindegree.Whileinvestment inmanagedfuturesor in long/shortequityhedgefunds have been accepted, pure option strategies and investment in illiquid assets are
generallystillshunned.Thecurrentregulatorypressureonderivativesisunlikelytoaffectplan
sponsorusageintheshort ormediumterm.
Chart1datacompiledfromVIXandVVdailyprices,aspublishedonBloomberg
**Manypensionplan sponsorsoutsource the specificassetmanagement functionand concentrate theireffortson
selectingthemanagersforeachassetclass.
8/6/2019 Tail Risk Hedging May2010
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Tail Risk Hedging: A Roadmap for Asset Owners
6
Is leverage allowed?
Many plan sponsors similarly limit the use of leverage within their portfolios. Although
leverage isnotwelldefined in thiscontext, for thoseplansponsorswhomaybe restricted
fromusingleverage,itisgenerallyacceptedthatleverageconsistsof: Directborrowingintheformofcreditfacilities(sometimespermissible)
Usingshortsaleproceedstofundlongpurchases
Embedded leverage that is inherent in certain financial products such as futures,
options,andstructuredproducts
Rulesandregulationsconcerning theseconceptsaregenerallystricter forERISAentitiesand
sometimeslessstrictlydefinedforsomeallocationbuckets(suchasisoftenthecaseforHedge
Fundinvestments).
Assetownersshouldconfirmandclarifyapplicablederivatives,leverage,andotherrestrictions
withtheirlegalcounsel.
What are the horizon and the expected rarity of the event to be hedged?
Plansponsorsneedalsodeterminetheoptimaltradehorizon.Thismustbeconsideredinthe
contextof theportfolioshorizon,whether itbe strategicor tactical,but ineithercase, the
implementationofthesolutionisdependentonthetypeandavailabilityofinstrumentexpiries
andmaturities.For instance: iftheselected instrument isanequityoption,adifferentsetof
considerationsapplythanifadirectindexinvestmentisselected.Inthecaseofequityoptions,
onemustconsiderexpiryof theunderlyingoptions (aswellasstructureand thenumberof
optionsrequiredtoachievethedesiredeffect),butindicesusuallydonothaveanexpiry.
Similarlyrelevantisoneofthemostspokenaboutcharacteristicsofstatisticaldistributions, .
Inessence,thelargerthenumberofsigma,themorerareaneventis(a6 eventismorerare
thana3 event).Dependingon themarket conditionsof theportfolio subset that isbeing
hedged,aneconomicdecisionabout hastobemadevisviscost(moreonthisabitlater).
Forinstance,ifanassetownerchoosestohedgeitsequitiesbook(S&P500)withvolatility,itcan
dosoviavarianceswaps,tailriskprotectionindices,orindexswaps.Moreinformationoneachof
theseisavailableintheHedgeExamplessectiononpage11.
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Tail Risk Hedging: A Roadmap for Asset Owners
7
What are the costs of hedging?Mostofthefactorsmentionedintheprevioussectionsaffectoverallcost,whichisoftentheasset
ownersprimary consideration.Cost analysis isnot simple, andunderstanding the factors that
affectitisimportant.Thesefactorsinclude:
Timing: Inrelativelycalmmarkets,impliedvolatilityislow.ConsideroptionsontheCDX.IGindex(anindexlinkedto125investmentgradecorporatecredits):thecostofCDX.IGindexoptions,
whichispartiallycomprisedofvolatilitypremium,islesswhenthecreditmarketiscalmthanit
isinturbulenttimes.The20092010creditmarketrallyhascreatedmarketstabilitythatmay
presentagoodopportunitytopurchaseprotection.Assetownersneedtobeawareofmarket
timingcontextwhenplacingahedge.
Liquidity:Liquidity isameasureofmarketdepthandofhowquicklyandreasonablyanasset
canbeboughtorsoldwithoutsignificantlyaffectingthemarket.Variousassetsdifferintheirliquidity:S&P500indexconstituentstocks,withaheavytradingvolume,areforthemostpart
moreliquidthanthoselistedontheTorontoStockExchange.Usuallyathinnertradingvolume
demandsahighertransactioncost.ThisrelationshipisalsoprominentintheOverTheCounter
(OTC)vs.Exchangetradeddiscussion.
Horizon:Theperiodoftimeduringwhichahedgewouldneedtobeineffectisthehedgestimehorizon. This concept is closely tied to both the timing concept and to liquidity, and by
extension, longerdated solutions are frequently more expensive. That said, for some
instruments, a sufficiently long maturity/expiry may not be available. For longerterm
strategies,considerindexinvestments,whichhavenomaturity.Forashorterhorizon,options
on theVIXwhichextendexpirysevenmonths into the futuremaybemoreeconomically
appropriate.
Trade Size: Dependent on trade mechanics, trade size can either significantly increase orcategorically decrease transaction costs.When operating in the CDS market, for example,
largernotionalvaluecanaffectrelativeliquiditydramaticallyandincreasecost.Inthecaseofa
highlycustomizedstructuredsolution,largernotionalvalueallowsforeconomiesofscaleand
reducesperunitcost.
Funded vs. Unfunded Instruments: Amajordeterminant in thecostofahedgewillbe
whether
the
instrument
chosen
is
a
funded
or
unfunded
vehicle.
Products
can
be
fully
funded,
requireonlyasmallpremiumpayment,orinsomecasesonlyrequireaninitialmarginamount.
Wehave illustrated thisproperty inTable3(a),wherewerepresent thecashoutlayofeach
hedge instrument by employing a relativemeasure indicator ($ requires less cash outlay
than$$).
Structure Complexity:Asolutionmaybesimpleandcomprisedofonlyoneinstrument(e.g.,put option on the S&P 500) ormore complex and be created from a series of individual
8/6/2019 Tail Risk Hedging May2010
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Tail Risk Hedging: A Roadmap for Asset Owners
8
instruments(e.g.,optioncollaronS&P500).Oftenthesemorecomplexstructuresarecreated
todiffusecost,suchasinthecaseofanoptioncollaronS&P500,whichcaninvolvebuyinga
putoptionandoffsettingthecostoftheputbysellingacalloption.Thiskindofsolutionsheds
cost at the expense of some hedging efficiencies. In addition, there are some bespoke
solutionsthat increasestructuralcomplexity inordertoachieveaneconomicpurposesuch
asabespokecreditdefaultswapbaskettrade.Thistradewouldbesimilartobuyingprotectionon the CDX.IG index (which references 125 companies) except that the bespoke swap
referencesaninvestorpickedsubsetofcompanies(e.g.7080preferredcompanies).Typically
bespokesolutionssuchasthesearemoreexpensive.
Service Provider Factors: The following parameters affect the cost of any proposedsolution:
Scale: Largerproviders can affordmoreeconomiesof scale,especially if they are a
market maker. Those with a broad geographical reach can also leverage product
diversity,marketexpertise,andoperationalefficiencies.
Counterparty credit/rating:Morehighlyratedentities ability toborrow at a lower
costtranslatestopotentialsavingsfortheirclients.
What are my monitoring constraints?
Monitoringisobservationandevaluationbyasystemorperson.Beforeimplementingahedge,it
is critical to consider theoperationalburden causedby thenecessityofmonitoring thehedge.
Propermonitoringshouldaddresswhetherthehedgeisperformingasexpected,ensurethatitis
notnearingitsexpiry/maturitytimeframe,anddeterminewhethermarketconditionscallforthe
terminationoftheposition.Whendiscussingmonitoring,consider:
Frequency: In general, positions should be monitored as frequently as possiblebutmonitoring frequency must also be evaluated on a casebycase basis. For less liquid
instruments, dailymonitoringmay not be possible, as their reported price often does not
changeasfrequently.InthecaseofanassetownerthatisanINHAM,theappropriateexisting
tradingteamoftenincludesthistaskinitsresponsibilities.
Metrics: Severalmetricsmust be considered in order to ensure thatmonitoring efforts aresufficientlythorough:
Price/MarktoMarket: Change in price is themost important indicator of how an
instrument/strategyactsasahedge.
Volume:Asanimportantindicatorofliquidity,changesinvolumemustbemonitoredas diligently as changes in price. Past experience has shown that liquidity shrinks
dramaticallyduringextrememarketevents.
Efficiency: It is recommended to monitor hedge effectiveness and periodically
reevaluate assumptions. Simplemeasures such as total portfolio value or complex
measures such as ValueatRisk are widely held to be acceptable methods for
measuringefficiency.
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Tools:Assetowners should consider their technical limitationsor strengths in the contextofmonitoringtoensurethatmonitoringcanbeperformedproperly.
Price:Althoughmostpricing levelsarereportedbymarketdataservices,someasset
prices can only be obtained from broker/dealers. In the case of these assets, a
relationshipwithabroker/dealeriscritical.
Portfolio: Portfoliomonitoring tools tomeasure hedge effectiveness are available
commercially,oroften,serviceproviderscanoffer reportsor theuseofproprietary
portfoliomonitoringtoolsuponrequestbesuretoask.
Collateral: Aspects ofmonitoring collateral are also subject to specialized systems
oftenprovidedcommercially.
Collateral: Some instruments, such as swaps, require careful monitoring to ensure propercollateral calculation and exchange of credit/debit between counterparties. There are also
manyproductssuitable to tailriskhedging thatdonot require theexchangeofcollateral. If
collateralmonitoringisoperationallyimplausible,theassetownershouldconsideralternative
solutions.Custodybankscantypicallyprovidethismonitoringservice.
Counterparty:Itshouldberememberedthatcounterpartyriskcanquicklybecomeanissueina tailevent scenario.This consideration ismore relevant in the caseofhedges thatdonot
clearthroughanexchange,butassetownersmustbecognizantofnewsandhappeningsthat
may affect their counterparties adversely. The most straightforward ways to reduce
idiosyncraticcounterpartyriskistofacethemosthighlyratedcounterpartiesandtodiversify
counterpartyexposure.
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RisksBefore a solution is implemented, it is worthwhile for the asset owner to be aware of the
spectrumofrisksinherentintheirdecision.Theserisksaresummarizedforeachtypeofsolution
inTable3(b).Forexample,anequityoptioncollarhasequityrisk,nonlinearityriskbecauseitsa
collectionofderivatives,operational riskbecause itneeds tobe rolledbeforeoratexpiry,and
somecareerriskfortheCIO/decisionmakerifhedgesdramaticallyunderperformexpectations.
Relevantrisksinclude,butarenotlimitedto:
Market risk:Alsoknownas systemic risk, this is the risk that iscommon toanentiremarketsystem. The value of investmentsmay decline over a given timeperiod simply because of
economicchangesorothereventsthatimpactthemarketatlarge.
Non-linearity Risk: Potential losses on derivative positions that are due to a nonlinear
relationshipbetween thepriceof thederivativeand thepriceof theunderlying instrumentthatthederivativereferences.
Credit Risk: Potential losses associated with the ratings upgrade, ratings downgrade,restructuring,ordefaultofa referenceentity.Recovery rates in theeventofeachof these
influencecreditriskaswell.
Counterparty Risk:Therisktoeachpartyofacontractthattheircounterpartywillfailtofulfillits contractual obligations. Counterparty risk is a risk to all involved parties and should be
consideredwhenevaluatingasolution.The importanceofconsideringthisriskhas increased
in
the
wake
of
the
unexpected
failure
of
several
broker/dealers.
Operational Risk: Potential losses associatedwith the executionof an investors systems,processes,andpersonnel.This includes tradingrisk, fraudrisks, legalrisks,physicalrisk,and
environmentalrisks.Inthiscontext,operationalriskreferstotheriskinherentintheprocess
ofhedging(analysis,synthesis,andmonitoring),andthecomplexitiesthatresultfromhands
onmanagement.
Career Risk:LooselydefinedaspotentialforlossofprofessionalcredibilityoftheCIO/decisionmakerduetoanadverseoutcomeofhedgingdecisions.Anindividualwhofollowsareasoned,
conservativedecisionmakingprocessshouldbeabletodeflectcareerrisk.
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Tail Risk Hedging: A Roadmap for Asset Owners
11
Hedge Examples
Asasupplement toTable3, includedherearebrief illustrationsofa fewstrategies thatcanbe
implemented toeffectivelyhedge tail risk scenarios tied to specificasset classes.Assetowners
shouldconsiderwhetheranystrategyisallowedorappropriatebeforeimplementing.
VarianceSwaps
TailRiskProtectionIndices
EquityOptionStrategies
CreditStrategies
InflationFloorAgreements
InflationHedge:EnergyIndices
ManagedFuturesIndices
SovereignRiskCommodityHedge
SovereignRiskRatesHedge SwapsonIndices
Variance Swaps
Avarianceswapisanoverthecounterfinancialderivativethatallowsonetospeculateonor
hedge risks associated with the magnitude of movement (volatility) of some underlying
product,suchasanexchangerate,interestrate,orstockindex.Inavarianceswap,twoparties
enteracontractonforwardrealizedvariance.Atmaturityitpaysthedifferencebetweenthe
realizedvarianceandthepreagreedvariancestrike. Varianceswapsprovidepureexposureto
the
underlying
price
volatility,
without
the
complication
of
delta
risk,
which
is
present
in
options.Theimplementationofvarianceswapsrequiresinhouseexpertiseinordertoanalyze
inclusionandsizinggivenaportfolio.
Tail Risk Protection Indices
Volatilitybased tail riskprotection indicesare rapidlybecomingapopular choiceasoverlay
equitytailriskhedges.DeutscheBanksELVIS index isonesuchexample.ELVISusesforward
varianceswaps toeffectivelygo longS&P500 impliedvolatility,whichavoids theotherwise
necessaryvolatilityriskpremiumembeddedinoptionprices.Historically,periodsofsevere
lossesintheequitymarkethavebeenmetwithupwardspikesinvolatility,qualifyingtheindex
asanappropriateandeffectivetailriskhedge.AddingDBELVISgrantsaportfoliosubstantial
downsideprotectionwhileminimizingcarryingcostsduringhealthymarketperiods.Contrary
tomanyotherstrategies,ELVISdoesnotrequireactivemanagementtomaintainprotection
which alleviates operational burden associated expiration/rollingand is structured in a
simpleandtransparentmanner.
DeutscheBanksEMERALDindexperformsinasimilarmanner,withadifferentstructure.DB
EMERALDseekstocapturereturnsbasedontheS&P500sdemonstratedtendencytomean
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Tail Risk Hedging: A Roadmap for Asset Owners
12
revert during the course of a single week, essentially generating returns while providing
downside protection. The performance of the index is tied to the spread between daily
volatility and weekly volatility, which has displayed consistent negative correlation. DB
EMERALDsadvantagesaresimilartothoseofDBELVIS: lowcostofcarry,noneedforactive
management, simple and transparent structure, and efficiency in hedging equity risk. It is
important tonote thatboth indices relyon thepersistenceof thehistoricnegativeequityvolatilityrelationshiptoperformasanticipated.
Equity Option Strategies
Traditionalputoptionstrategiesareamong themoststraightforwardapproaches toactively
hedging equity risk, and are also among the most effective if implemented properly.
Historically, longdated 70% strike puts on the S&P 500 have been a popular choice, since
options are illiquid at strikesbelow 70%, and therefore generallymore expensive. Thisput
strategyiscomparativelycheap,moderatelyliquid,andeffectiveinseveremarketdownturns.
Operational
drawbacks
include
cost
volatility,
additional
fees
associated
with
rolling
the
position,andthenecessitytomonitorpositionsaroundexpiry/rollperiod.
Employing tailored option strategies involves combining puts and calls, and in some cases
overthecounter instruments, to develop a specific hedge profile. Put spreads and putcall
collarsarecreatedtodiffusecost.ConsideranoptioncollaronS&P500,whichinvolvesbuying
aputoptionandoffsetting thecostof theputbysellingacalloption.Thiskindofsolution
sheds cost, but at the expense of some hedging efficiencies. Additional features can be
structuredtoallowaninvestorflexibilitytotailorthehedgetoanyparticularmarketoutlook.
Relative to traditional put options, tailored option strategies are inherentlymore complex,
requiremorecarefulmonitoring,andcanbelessliquid.
Credit Strategies
Therearefourcredithedginginstrumentsthatarecommonlyavailable:
Creditdefaultswaps(CDS)onindividualissuers:Forexample,buyfiveyearprotectiononGE
default
CDSindices:CDX.IG(investmentgrade)andCDX.HY(highyield)arethemajoravailableindices
inUScorporatecredit.ThereisalsoaliquidlytradedindexthataddressesSovereignrisk.
OptionsonCDSindices:OptionsareavailableontheCDX.IGindex
Tranches(slicesofvaryingseniority)onCDSindices:TranchesareliquidonCDX.IGandCDX.HY
CDSon individual issuers isused toexpressabearishviewonorhedgeexposure tospecific
names, or sets of names (perhaps a sector). This approach is less appropriate for macro
hedgingortailriskhedgingexceptwhentheissueritselfisasystemicallyimportant/tailrisk
sensitive entity for example, buying protection on financials, insurance companies, and
sovereignshavebeenusedastailriskhedgesinthepast.
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ThemostliquidlytradedUSCDS index istheCDX.IG,whichreferences125investmentgrade
corporate credits. This is an active strategy that facilitates straightforward and transparent
exposuretotheCDSmarket.OptionsonCDSindicesallowinvestorstobuycallorputoptions
onmovementsoftheCDSindicesthesecanbeusedtocreatenonlinearpayoffprofiles,with
relativelylowcashoutlay,thatareoftendesirableinthecontextoftailriskhedging.
Hedgerscanalsobuyprotectiononspecificslicesoftheindexviathetranchemarket.CDX.IG
tranchesareavailable inslicesofvaryingseniority.Eachtranchehasdifferentsensitivitiesto
idiosyncraticdefaultrisk,economicdownturnrisk,andtailriskwhichallowsforfinetuningto
obtain thedesiredexposure.Todetermine themostappropriateslicegivendesiredpayout,
risk profile, and market conditions, we urge asset owners to discuss the topic with their
trusted advisors.HedgingwithCDX is lowcost, and ismore liquid thanpurchasingCDSon
individual names. Historically, over the long term, CDX hedges had underperformed other
credithedges,andmightbebettersuitedforshorterterm(ormorefrugal)hedgingpurposes.
Bespokesolutionscanalsobecreatedtoimmunizeaclientportfoliosexacttailriskprofile.
For corporatepensionplan sponsors looking toadd creditaspartofan LDI (liabilitydriven
investment)strategy,sellingprotectiononindividualcreditsorindicesmayproveanefficient
meanstoachievethisresult.
Inflation Floor Agreements
Tohedgeagainsttheproblemofincreasedunderfundednessinadeflationaryenvironment,an
asset owner can purchase options that are structured to compensate the owner precisely
whenthisbecomesaconcern. Inflationflooragreementsarestructuredtopayatmaturity if
the cumulative inflation over the lifeof the contract is less than the strike. Inflation floors
performoptimallyindeflationaryscenarioslastingmultipleyearsorinselectyearsthatexhibit
severedeflation. Inflation floorsmustbe rolledperiodicallyandhence requireoperational
diligence tomaintainprotectionand are among themore involved strategies available to
achievetailriskhedging.Cumulativeinflationfloorsarebestusedasportfoliolevelhedges.
Inflation Hedge: Energy Indices
Financialassetssuchasequitiesandbondsfacetheriskoflossfromanunexpectedincreasein
the rate of inflation, which affects the rate at which cashflows are discounted. Hedging
unexpected inflation can be performed in numerous ways, but because a significant
component of these unexpected changes has historically been driven by food and energyprices,a swapona targetedcommodity indexmayproveanefficientand liquidmethodof
achievingthishedge.WerecommendalongonlyinvestmentintheDBOptimumYieldEnergy
Indexasahedgeagainstunexpectedinflation.
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Managed Futures Indices
Asdiscussed, an investment inmanaged commodity futures can serve tohedgeequity risk
throughdiversification.AnexampleofsuchaninvestmentvehicleisDeutscheBanksMATRIX
index,whichprovides thisexposureby referencing abasketof commodity trading advisors
(managers).Managedfutureshaveexhibitedexceptionalperformanceoverotheralternativestrategies during periods of severe market stress, and demonstrate a real diversification
benefitduringtheseperiods. InitialcashoutlayforDBMATRIX is low iftradedviaswap,and
thisstrategycomeswithlowoperationaloverheadsincethereisnoneedtorollorrebalance.
Sovereign Risk Commodity Hedge
In the eventof a sustained andwidespread sovereign risk spillover in Europe, themarkets
shouldpursue flight to safehavenassets suchasGold, followedbya reduction in capital
expenditureandeconomicgrowth,whichwouldbereflectedinlowereddemandforindustrial
commodities
such
as
Aluminum
and
Crude
Oil.
To
protect
against
such
sovereign
risks,
we
suggestbuyingaworstofoption includingacallonGold,aputonCrudeOil,andaputon
Aluminum.Thisportfoliooverlaystrategyhasavery lowpremium (typically~95bps fora1
yearoptionstruck5%outofthemoney)withmaxlosslimitedtothepremiumpaid.
Sovereign Risk Rates Hedge
Inasovereignriskspilloverevent,alowUSDrateenvironmentwouldlikelyprevail.Toposition
againstthisscenario,managerscanpurchasealowstrikereceiverswaptioninUSDasahedge.
Thisoptiongivesthebuyertheabilitytoenterintoacontractinwhichhereceivesafixedrate
whilepayinga floatingrate(typically3monthLibor). Ifa lowUSDrateenvironmentensues,
thebuyerof theoptionwillprofit asheowns a contract that entitleshim topayments at
abovemarketrates.
Hedging Liabilities with Options
AsdiscussedinWhatarewehedging?onpage3,adeflationaryenvironmentisproblematic
forpensionplansponsors.AplansponsorcanuseswaptionstrategiessuchastheSovereign
RiskRatesHedgeabove toprotect funded status fromadeclining rateenvironment.These
strategiescanbecustomizedtoaninvestorstimehorizonanddesiredcoststructure.
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Longevity Swap
As thepeakof thebabyboomer retirementwaveapproachesand retirees continue to live
longer,marketsaredevelopinghedgingsolutionstohelppensionplansmanagethevolatility
of their liabilities. One targeted approach is via a swap that effectively hedges benefit
payments beyond projected life expectancies. In the swap, sponsors pay a fixed stream ofpayments (determined at the inception of the longevity hedge and representing the best
estimateofprojectedpaymentstopensionersplusamargin)andreceiveanyactualpayments
owedtopensioners.Thisreducesthesensitivityoftheplantochangesinthelifeexpectancy
of its members. This opportunity exists due to the recent growth and maturation of the
longevitymarket, aswell as theemergenceofnewmarketparticipantswho seek longevity
exposure.
Swaps on Indices
Swaps
are
an
effective
way
to
realize
the
performance
of
an
underlying
index,
such
as
DB
ELVIS, DB EMERALD, DB MATRIX, or DBLCI (the DB Liquid Commodity Index) without the
drawbacksofusingbalancesheet.Theswapstructureissimpletounderstandandtoenter.By
paying a negotiated ratetypically a fixed spread over Liborand receiving the realized
performanceoftheindex,equitytailriskprotectionisgainedwithminimalcapitalcommitted.
Drawbacks of using swaps can include compromised liquidity, necessity to negotiate ISDA
agreementswith the service provider, and the necessity to roll forward contracts as they
expire.Othermorecomplexvariations(e.g.,notes)canalsoexist.
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Table 3 (a): Asset Tail Risk Hedging Decision Table ConsiderationsWhatare we
hedging?
Active hedgingor
Diversification?
Whatrisk do we h e d ge ? W ha tdo we hedgewith?
Ins trume nt Ca s hOutla y Liquidity
(Y/N) (Y/N)
Domestic
Equi ty Acti veDownturn/Vol ati li ty EqOption Collar $
Variance swa ps $
IndexEMERALD $
Index(ELVIS) $
Options on VIX $$
InternationalEq ui ty Acti ve
Downturn/Vol ati li ty EqOption Collar $
Variance swa ps $
FXRi s k FXOption $$
FXIndex(MSCI EAFEFXHEDGEindex) $
Tre a s uri e s Acti ve
Inflation /Rate I n cr ea s e P aye rswa p $
Payerswaption $$
Cap $$ D ive rs i fi ca ti on Ge ne ra lPortfolio
Index(DB AgFI ) $
Enhanced Index(PULSE) $$
Corpora te s Acti ve
CreditRi s k CDXIndex $$
CDXindexoptions $
IndexTranches $$$
Rea l As s e ts Acti ve
Rea l Estate Exp os ure Swa pon NCREIF $$
FX/Commodi ti es Opti ons $
Futures $$
Forwards $$
D ive rs i fi ca ti on Ge ne ra lPortfolio
Index(DBLCI) $
Enhanced Index(DB Hermes Enh.Comm.Index $$$
Enhanced Index(DB Matrix ManagedFutures $$$
Enhanced Index(DowJones UBS Booster) $$$
Swapon Indices $
TIPS Index(TIPS) ETF $$$$
Alternative As se ts Acti ve
HedgeFundExp os ure Op ti onon Index(HFRI) $$
Are you
an
INHAM?
Can yo
us e a
QPAM
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Table 3 (b): Asset Tail Risk Hedging Decision Table Risks
Whatare we
hedging?
Activehedgingor
Diversification?
Whatriskdo we hedge? Wha tdo we hedge with?
Ins trume nt Eq FI Commod FX No
DomesticEqui ty Acti ve
Downturn /Vol ati l i ty EqOptionCollar high low low low
Variance swaps high low low low
IndexEMERALD high low low low
Index(ELVIS) high low low low
Options on VIX high low low low
InternationalE qu i ty A cti ve
Downturn /Vol ati l i ty EqOptionCollar high low low low
Variance swaps high low low low
FXRi s k FXOption low low low high
FXIndex(MSCI EAFEFXHEDGEindex) low low low high
Tre as uri es Acti ve
Inflation /Rate I ncre as e Pa yerswap low high low low
Payerswaption low high low low
Cap low high low low
D i ve rs i fi ca ti o n G en era l Portfolio
Index(DB AgFI) low high low low
Enhanced Index(PULSE) low high low low
Corporates Acti ve
CreditRi s k CDXIndex low high low low
CDXindexoptions low high low low
IndexTranches low high low low
Real As s e ts Acti ve
Real Estate Expos ure Swa pon NCREIF low low low low
FX/Commodi ti es Opti ons low low high high
Futures low low high high
Forwards low low high high
D i ve rs i fi ca ti o n G en era l Portfolio
Index(DBLCI) low low high high
Enhanced Index(DB HermesEnh.Comm.Index) low low high high
Enhanced Index(DB Matrix ManagedFutures) low med med med
Enhanced
Index
(Dow
Jones
UBS
Booster) low low high high Swapon Indices low
TIPS Index(TIPS)ETF low high low low
AlternativeAs se ts Acti ve
Hedge FundExpos ure Opti onon Index(HFRI) med med low low
SystemicRi s ks
dependsonindexswapped
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DisclaimerThismaterialwaspreparedby aSalesorTrading functionwithinDeutscheBankAGoroneof its
affiliates(collectivelyDeutscheBank).Thismaterialisnotaresearchreportandwasnotprepared
orreviewedbytheDeutscheBankResearchDepartment,andtheviewsexpressedhereinmaydiffer
from those of the Research Department. Sales and Trading functions are subject to additional
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Tail Risk Hedging: A Roadmap for Asset Owners
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