Cheap tail protection

February 28, 2011 06:00 PM

Everyone is looking for tail insurance these days. Asset managers the world over, brusquely awakened by the brutalities of the credit crisis, desperately are searching for hedges that would shelter them from extreme market events, the probability of which now are deemed significant. In contrast to the situation prevalent pre-crisis, those actively seeking crash protection are so numerous that the price for such strategies has skyrocketed.

Many alternative tail-hedging strategies have been suggested by experts and commentators, but only a few truly protect from a sharp decline in asset prices. Inflation, volatility, commodity, currency and Volatility Index (Vix) hedges, for instance, have been proposed as cushions for stock market investors.

But these are not straightforward hedges. They may or may not end up providing cover should equity prices tumble, and there likely is going to be a severe mismatch between losses incurred and compensation payments. (The hedge would suffer from substantial basis risk.) Even assuming that volatility or gold would shoot up as stocks dive, who’s to say that the gains from the former positions would offset perfectly the setbacks from the latter? You would need to know beforehand the precise future correlation between volatility or gold and stocks — a decidedly implausible task.

The only way to obtain sufficient tail insurance for a long equity play (or long any asset class) is to buy equity puts. As the market tanks below the pre-selected put strike, you will receive an amount of money commensurate to your cash losses below that point.

Unfortunately, puts (even far out-of-the-money puts) can prove costly following a historic crisis that has made everyone more receptive to the idea that crashes happen. Rather paradoxically, those who didn’t believe in the rare event helped cause the meltdown that unavoidably highlighted the ubiquity of the rare event, resulting in much more expensive tail protection. An ounce of protection may be worth a pound of cure, but since no one spent the ounce in ‘08, it is now more expensive.

While managed futures have been shown to provide "crisis alpha" (see "Diversify with crisis alpha," February 2011), some folks are prohibited from certain derivatives. There are, though, innovative ways to lower the price of put cushioning, if you are willing to venture into exotic territory.

One possible strategy can be termed "gapped tail insurance." You gain protection from disaster and mega-disaster scenarios, but not in between. The final tab could be significantly cheaper than a plain vanilla put. The hedge would be just like a put’s, except for the region (the gap) where you are unprotected. Should you decide that such risk is probabilistically negligible, you can employ this strategy to shelter yourself economically from meltdowns.

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About the Author
Pablo Triana is the author of "Lecturing Birds On Flying: Can Mathematical Theories Destroy The Financial Markets?" (John Wiley & Sons).