Wednesday, January 29, 2014

Bhansali, Tail Risk Hedging

Vineer Bhansali’s Tail Risk Hedging: Creating Robust Portfolios for Volatile Markets (McGraw-Hill, 2014) is a book that unfortunately will never reach a mass audience. I say “unfortunately” because by and large investors are horrible risk managers. Most have long-only portfolios; the savvier among them pride themselves on being diversified. But in a major sell-off, where correlations usually increase dramatically, they are unprotected and will most likely end up bloodied.

Bhansali argues that “typical investment portfolios … suffer from too much asset-class diversification and not enough risk diversification.” (p. 184) The problem is that “even assets that are fundamentally uncorrelated may become correlated on the tails if they are affected by a common liquidity factor.” (p. 18) This problem, however, can be converted into an opportunity. “For example, if we believe that there are concentrated carry positions in some currency pairs that will come under liquidation pressure if the equity or credit markets come under pressure, then a carry currency put option bought in advance of the stress would prove to be a cheap way of hedging.” (p. 19)

Bhansali emphasizes that “the use of market-traded options is a simplification that works only if the underlying hedge objective is rather plain vanilla. If the objective is more complex, for example, ‘hedge so that at no point in time does the portfolio suffer a loss of more than x percent,’ the reference index security would have to be more of an exotic option such as a knock-in option.” (p. 41)

Options are not the only way to hedge tail risk. “We should use cash, diversification, alternatives, and explicit hedging within a consistent cost-benefit tradeoff to construct the most efficient and practical solutions.” (p. 43)

Bhansali explores the advantages of static hedges versus dynamic hedges. “In static hedging, the buyer of protection buys a contractual obligation that if a particular event were to happen, the seller of the protection would pay according to a predefined formula. By contrast, in dynamic hedging, the protection seeker uses some algorithm to create the payoff he would have as if he had actually purchased the static hedge but without actually paying for the hedge now. In other words, static hedging is outsourcing of risk management to the options, whereas dynamic hedging is doing option replication in-house. In practical terms, static hedging consists of buying options, for example, S&P500 put options or indirect options, whereas dynamic hedging is done by replicating the option using the underlying instruments, for example, by selling and buying S&P500 futures.” (pp. 146-47) Bhansali suggests that the investor should “pay as you go for small losses using rebalancing and dynamic hedging, but … combine this strategy with sufficient static hedges on the tails to avoid the possibility of permanent losses from the rare but severe fat tails.” (p. 152)

When trying to hedge tail risk for retirement accounts, the investor is confronted with “the interplay among risk aversion, horizon, and the dynamics of markets over long periods of time.” The author says that everything he has written about tail hedging for asset allocation “still holds true, such as the need for active management, its role as an offensive risk-management tool, and its role in mitigating downside risks. However, the introduction of time to retirement and risk tolerance as new variables makes the exercise even more complex and fruitful.” (p. 186)

Although Bhansali oversees PIMCO’s quantitative investment portfolios, he introduces relatively little math in this book. The reader should, however, be familiar with options and the basic metrics of risk management.

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