Tail Risk Hedging Strategies: Are They Effective?

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Portfolio hedging is a risk-management practice that uses a number of strategies to mitigate the risks of any given portfolio. Tail risk hedging in particular is one of the techniques used in equity portfolio management. It basically involves buying put options in a certain amount to partially or fully protect the portfolio.

Reference [1] provided an in-depth study of different tail risk hedging strategies,

In this paper, we contributed to the limited literature on using actively managed put options as tail hedges. We investigated whether a put option monetization strategy can protect an equity portfolio from drawdowns and enhance its returns. We have done so by applying eight different monetization strategies, using S&P 500 put options and an underlying equity portfolio represented by the S&P 500 Total Return index, during the time period 1996 to 2020. We have compared the results from the strategies with an unhedged position in the chosen index, and with a constant volatility strategy applied on the same underlying.

The article pointed out that as compared to an unhedged index position, tail risk hedging yielded worse results both in terms of risk-adjust and total returns.

Over the course of the 25-year period, all the strategies’ total returns and Sharpe ratios are inferior to the unhedged index position. The observed results suggest that rule-based monetization strategies are not able to adequately reduce drawdowns, less, enhance returns of the portfolio compared to the unhedged position.

The results make sense since buying puts means paying for the convexity, i.e. the volatility risk premium. However, we believe that the hedging costs can be further minimized by optimizing for the strikes and maturities. There should exist optimal strikes and maturities where the volatility risk premium is minimized. Along this line, the authors also noted,

The observed results might be sensitive to the chosen representation of the equity portfolio and the investigated time period. Furthermore, the results could be sensitive to the choices of time to expiry and moneyness of the bought options in the tested strategies. Active money managers could also try and exploit increasing correlations in swift market declines with the use of indirect hedges.

Finally, portfolio managers can also use other hedging strategies such as indirect hedges or diversification.

References

[1] C.V. Bendiksby, MOJ. Eriksson, Tail-Risk Hedging An Empirical Study, Copenhagen Business School, 2021

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