Implementation strategies for tail risk hedging
Equity options
One basic approach to tail-risk hedging is purchasing out-of-the-money puts or put spreads on equity market indexes such as the Standard & Poor's 500, NASDAQ 100, FTSE, and others. Equity index options markets are well developed and generally the most liquid of options markets. For tail risk purposes, implementation can take the form of:
Buying 20% OTM puts;
Buying 10%/20% OTM put spreads;
Buying 40% OTM puts;
Buying 20% OTM knockout puts.
An equity options strategy should be a dynamic approach rather than a passive one. Option premium is typically expensive — purchasing protection and leaving it alone will be costly from an implementation perspective. An active strategy that rolls option protection up or down as the markets fluctuate is generally cheaper, even when taking transaction costs into account. For instance, a dynamic 20% OTM put strategy which readjusts every time the market moves 20% up or down will outperform a static strategy, especially as market fluctuations increase.
Variance swaps
Variance swaps entered the investment scene in the late 1990s as a vehicle for trading realized variance expectations. They are over-the-counter forward contracts on realized variance. In effect, a buyer of a variance contract agrees to swap a fixed variance level K' for actual realized variance v' from now until the maturity date. As such, variance swaps provide pure exposure to realized volatility of an asset. They can be used to take views on future volatility, to capture the spread between realized and implied, and to hedge asset volatility exposure.
Theoretically, the pricing of a variance swap is directly proportional to the fair value of a “log-contract” on the underlying asset (a contract that pays the logarithm of the price of the asset). This contract can be replicated in static fashion using weighted linear combination of call and put options. Variance swaps are therefore priced by dealers as a basket of puts and call options. Variance swaps have been standardized to the point that the International Swaps Dealer Association added annexes to its Master Agreement in July 2004 to cover variance swaps on stocks and stock indexes. (The ISDA Master Agreement is the main legal agreement used in the over-the-counter global derivatives market.)
A tail risk hedging strategy would involve purchasing a basket of variance swaps on equity, fixed-income, currency or commodity indexes. Due to the inherent “amortizing” nature of variance swaps as they mature, the strategy would be a straightforward and static implementation.
Swaptions and swap spreads
The theory behind hedging interest rates using swaps and swaptions is widely understood. To hedge interest rate tail risk, purchasing OTM swaptions is analogous to buying OTM equity puts for hedging equity risk. Again, a dynamic approach will be more cost efficient than a static one.
Swap spreads, the rate differential between an interest rate swap and its equivalent U.S. Treasury, have traditionally been used as an indication of credit conditions in the financial market. When this spread is narrow, banks are viewed favorably in terms of creditworthiness. During tail-risk events, swap spreads can rise significantly. Similarly, agency spreads are an indication of mortgage creditworthiness, commercial paper spreads are an indication of corporate creditworthiness, and the list goes on. The key takeaway is that during times of financial market stress, these typically stable and well-behaved spreads increase significantly and rapidly to potentially extreme levels.
A tail risk hedge strategy would involve entering into a basket of OTM options on various spreads. The strategy can be implemented statically because spreads are typically stable and only move during stress events.
Credit default swaps
The negative press around credit default swaps is probably well deserved in many cases. Nevertheless, they can serve a useful purpose for hedging tail risk. Credit default swaps are actually options, where a buyer pays a premium (the credit default swap rate) annually for protection from a bond default. This could be a corporate bond, a mortgage bond, a pool of asset-backed loans, commercial mortgage loans, levered buyout loans, etc.
Credit default swaps on market indexes have been created to represent various portions of the fixed-income market, including: CDX for corporate bonds; ABX for subprime mortgage bonds; CMBX for commercial mortgage bonds; and LCDX for leveraged bank loans.
Furthermore, CDS are often traded on the tranched collateral behind these bond/loan indexes.
A tail risk implementation would involve purchasing a basket of credit default swaps on several of these indexes, tailored to the exposures that exist in the portfolio. Alternatively, an opportunistic strategy could be employed because CDS on the top tranches of market indexes are sometimes the cheapest hedges out there.
Correlation swaps
Correlation swaps evolved from the active dispersion trading in the options market. Dispersion trades seek to take a view on the correlation of individual stocks within a stock index and involve buying and selling options on the index and the constituent stocks. Market innovation has yielded the correlation swap. For example, a buyer of a Nasdaq 100 correlation swap essentially takes a view that future correlation realized by the individual constituents of the Nasdaq 100 will be higher than the agreed upon swap level.
As seen last year, correlations among all assets rise significantly during times of market stress. A tail risk hedging strategy would involve purchasing correlation swaps to hedge against this rise in correlation. This static approach must necessarily be opportunistic in nature, since it would be difficult to explicitly link actual portfolio exposure to index correlation.
