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Is Timing Everything? Practical Implementation of Tail Risk Hedging​​

Timing of hedging decisions matters, but what you buy and how you structure your hedges is equally important.

The natural tendency of most investors is to seek hedging against market volatility when markets become bearish and to eschew any hedging expense when market sentiment seems very bullish. As a result, most investors tend not to hold hedges exactly when they may be most attractive – near market peaks when implied volatility is at its lows.

At its core, “just in time” hedging is merely speculation. It is akin to purchasing earthquake or flood insurance only during times when you expect a natural disaster is imminent – and similarly to natural events, market conditions are very difficult to forecast.

For example, based on the VIX index – the Chicago Board Options Exchange’s Volatility Index, which measures the implicit cost of hedging – markets were moderately concerned but not expecting a deadlock as the U.S. Congress approached the edge of a “fiscal cliff” at the end of 2012. When it became apparent that there might in fact be a standoff, the VIX rose sharply higher, and then collapsed on the first trading day of the new year after an agreement was reached on 1 Jan 2013 (see Figure 1). Waiting until the last minute to hedge would have proven very costly in this case, as options purchased in the last few days of 2012 collapsed in price in 2013.

The chart is a line graph showing the level of the VIX (the Volatility Index, published by the Chicago Board Options Exchange or CBOE) from mid-September 2012 to mid-February 2013. Over the period, the VIX falls to 12 by February 2013, down from around 14 in September 2012. The graph shows a steep peak of greater than 22 in late December 2012. It plummets after that, and drops into a new range below 14 by early January 2013. Afterwards, it mostly trades below 14 within this time frame.

Theoretically, if the investment horizon were infinite, hedging might not be necessary. Over long periods of time, an investor may incur positive returns from many sources of risk premium. Even in the case of very long horizons, however, the contingent liquidity that tail risk hedging (TRH) generates in a market crisis affords investors the opportunity to buy assets at distressed prices, and hence may be an attractive addition to an asset allocation. 

In practice, though, few investors are able to dismiss investment risk as a “short-term fluctuation.” Reporting to stakeholders usually takes place at least annually, and over the short run there can be considerable volatility. In addition, pension funds and others who are making substantial payouts on a yearly basis will find that making these payouts funded by sales of assets at extremely depressed prices can have a severe impact on future performance. For investors who have a substantial amount of risk assets in their portfolio, TRH can make it easier to maintain or even increase this return-seeking allocation, given the expected reduction in exposure to left-tail risks.

Is timing everything?

The cost of hedging can vary significantly over any given timeframe, and “just in time” hedging is nearly impossible: By the time an investor decides to hedge, the market correction may have already begun, and hedging may have already become expensive. Ideally, then, hedges could be included as a permanent part of an asset allocation and hence would be in place when most needed – what we might call “just in case” hedging. And even in a rising market, TRH can add value, providing a “trailing stop” to the portfolio that may give investors more comfort in maintaining their allocations to risk assets when markets rally.

In fact, some investors may consider a counter-cyclical approach: varying the amount of hedges purchased based on the level of implied volatility. A simple way of accomplishing this is to set a fixed budget and spread purchases over time. If options are expensive, the fixed budget buys less hedging, and if they are cheap, some of the budget can even be held back for a later period as long as the desired hedge ratio is accomplished. And since hedging tends to be cheapest when equity markets are at their peaks, and vice versa, an investor can potentially use this counter-cyclicality to their advantage (see Figures 2 and 3).

Figure 2 is a line graph showing the inverse correlation of the VIX and S&P 500 performance, from October 1990 to October 2014. Over periods of rising equity markets within this time frame, the VIX tends to be low. For example, from the market bottom in 2009, the chart uses arrows shows a strong uptrend for stocks, and strong downtrend for the VIX. Stock market peaks in 1999 and 2007 show periods of relatively low volatility. The graph over the time period uses a gray background to highlight quantitative easing periods (i.e., times with the Federal Reserve engaged in asset purchase programs in an effort to bolster the U.S. economy) in 2008-2009, 2010, and 2012-2014. Figure 3 uses a line graph to illustrate hypothetically how when the cost of hedging is low, more of a portfolio can be hedged. The graph covers the period March 2008 to March 2014. In March 2008, the cost of hedging, scaled on the right, is around 100 basis points for a 15% attachment point hedge in a 60/40 portfolio. Around that time, 60% to 100% of the portfolio is hedged, shown by a scale on the right of the graph. The graph also shows that during the financial crisis in late 2008 and early 2009, the cost of hedging soared to as high as more than 500 basis points, and the percent of the portfolio hedged drops to less than 20%. In 2013 and 2014, hedging costs are less than 100 basis points, and most of the time the percentage hedged is above 100%, reaching as high as 140%. Further details are in the notes below the figure and the surrounding text of the article.

When considering spreading purchases over time, one practical methodology in today’s steep volatility term structure could be to implement 1-year hedges in a laddered fashion, purchasing ¼ of the targeted notional value each quarter. Each tranche would hedge 25% of the total portfolio for 1-year from the execution date, and with a tail risk hedge level that is set relative to market levels on the execution date. In this way, the hedger will have both time and strike price diversity in the hedge portfolio (see Figure 4).

Figure 4 is a diagram illustrating a laddered hedge purchase strategy, of how one-quarter of the total notional each quarter gets rolled starting at the end of Year 1. By the end of Year 2, the entire notional value has been rolled.

Alternatively, one could purchase full notional for a quarter and continue rolling 3-month options. One downside of this shorter-dated option strategy is that it comes with little time value. It may be cheaper, but at the same time, if a significant market event takes place, shorter maturity options are unlikely to provide as much of a hedge as staggered longer maturity options do.

The indirect approach

Timing is not everything – what you buy and how you structure your hedges is equally important. Volatility is not uniformly priced in every market, and from time to time, investors may be able to purchase cheaper hedges using correlated hedge instruments in other markets.

As an example, when markets experience a sharp correction, currency markets may reflect repatriation flows. In that event, currencies with higher yields will tend to sell off and currencies with lower yields will tend to appreciate. (This is often called an unwind of the carry trade.) For instance, note how the correlation of the Australian dollar (AUD) with the S&P 500 becomes stronger when there is a pronounced equity market selloff (see Figure 5). If the out-of-the-money (OTM) options markets price to the average correlation (50%) instead of the tail correlation (60%), then the price of the OTM AUD put may be as much as 30% cheap to the S&P 500 put – a significant savings.

Figure 5 is a bar chart showing the correlation between S&P 500 and AUD (Australian dollar) spot price as a function of trailing S&P 500 returns over the time frame 2000-2013. When trailing returns are negative 25% or more negative, the correlation between the S&P and AUD spot is around 0.62, its highest on the chart. As returns increase, the correlation generally decreases. For trailing returns between negative 25% and zero, the correlation is 0.5. For returns between zero and 25%, the correlation is around 0.45. And for returns greater than 25%, the correlation is just above 0.45.

Because the choice of hedge instrument will change depending on market conditions, these proxy hedges can be actively managed. For example, if a currency proxy hedge suddenly becomes more valuable relative to the direct hedge, it may make sense to take profits on that indirect hedge, and rotate to other hedges or even direct equity puts.

Note that the use of indirect hedges does not come without some additional risk. Because proxy hedges may fail to perform in line with direct hedges, and therefore result in poor hedging against the specified risks, they should be used in moderation and in conjunction with direct hedges. The idiosyncratic risk associated with each proxy hedge can also be moderated through portfolio diversification – in other words, purchasing a portfolio of different proxy hedges in order to reduce exposure to any one specific indirect hedge. Along with this, proper management of a TRH portfolio requires a robust set of tools to quantify and limit this basis risk.

Funding the hedges

In most portfolios, we find that financing a hedging program can be accomplished entirely through raising funds from existing investments and using the proceeds to purchase options. However, some investors may consider these outlays too large for comfort.

Options markets can help – investors can choose to sell some options to finance purchase of the hedges. We are not advocating the use of collar strategies, as these can be very costly – for example, an investor hedging an equity portfolio using collars from 2009 to 2013 would have paid on average over 8% of the hedge amount in losses on the sold option as the markets rallied and the volatility curve “rolled up” (see Figure 6).

Figure 6 is a table showing how collar strategies can be expensive. The table includes various dates with the S&P 500 close, 108% cap level and cost at expiration. Average annual cost is 8.33%.  Data through 2 January 2014 are detailed within.

Therefore, we believe that sold option positions should be complementary to the overall investment strategy. For example, for a pension fund with a long-duration liability and an objective of obtaining more duration as yields rise, swaptions could allow the pension plan to “pre-commit” to extending duration at higher yields by selling payer swaptions above current yield levels. Proceeds of these swaption sales could then be used to finance purchases of equity puts and indirect proxy hedges. In this case, the investor is taking advantage of the natural positioning in the portfolio to reduce the hedging cost.

Figure 7 offers a numerical example of this approach: A plan aiming to hedge $100 million of equity exposure could sell $100 million of payer swaptions 100 basis points above the current market yield.

Figure 7 is a table that shows two types of options contracts, their price, and a description. Information is detailed within.

Very careful strategy planning is required for these combined approaches, and stress testing and scenario analysis in relation to collateral needs may be important.

Hedging strategies: key takeaways for investors

Timing of hedging decisions matters – purchasing hedges at their most expensive reduces the efficacy of hedging, since the market already prices in significant risk of a tail event. At PIMCO, we believe that tail risk hedges have a place in any portfolio that has a substantial allocation to risk assets. However, timing the entry point for a hedging program is unlikely to be possible, and so the optimal strategy may involve averaging into a hedging allocation, beginning at a time when equity prices are high and the cost of hedging is low, as appears to be the case now, given current S&P 500 and VIX levels.

In addition, using a broader set of hedge instruments may help lower the costs. When combined with a disciplined approach to cost averaging and potential sale of some options to finance the overall hedging program, it may be possible to mitigate a large part of the cost of the overall hedging program.

The Author

Michael Connor

Derivatives Strategist, Quantitative Strategies

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Additional Information

Tail risk hedging program: An actively managed portfolio of option positions (an investment hedge portfolio) designed to mitigate losses stemming from portfolio investment risks in a reference investment portfolio over an investment hedge horizon, with a specific attachment point and a specified expense level.

Portfolio investment risks: Dominant portfolio investment risks are quantified as investment risk factors which can include broad equity, foreign exchange, interest rate duration, and credit spread. During periods of volatility, policy and liquidity factors can be important.

Investment hedge horizon: Typically six months to five years, usually one year.

Attachment point: The targeted maximum loss at the investment hedge horizon of the combined reference investment portfolio and the investment hedge portfolio. Not a guaranteed number, the loss threshold should be considered an investment objective.

Expense (cost) level: The cost of a tail risk hedging program is a periodic expense, expressed as a percentage of the reference investment portfolio, for example, 1.2% per annum. Expense levels are determined at the outset of the tail risk hedging program but can vary over time either because market conditions change or because the client chooses to alter the hedge horizon or the attachment point.

Direct and indirect hedges: Direct hedges are options contracts whose values are driven by investment risk factors that are explicit risks in the reference investment portfolio. Indirect hedges are options contracts whose values are driven by investment risk factors that are not explicit risks in the investment portfolio or whose size is larger than necessary to directly hedge an explicit risk.

Past performance is not a guarantee or a reliable indicator of future results.
Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.Equities may decline in value due to both real and perceived general market, economic and industry conditions. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not assure a profit or protect against market loss. Investors should consult their investment professional prior to making an investment decision.

The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included. Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.

Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market.

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