TAIL RISK HEDGING: Creating Robust Portfolios for Volatile Markets
Introduction xv
Acknowledgments xix
Chapter 1: Introduction to Tail Risk and Tail
Risk Management 1
Lessons Learned 1
Distressed Liquidation and Failure of Diversification 18
Chapter 2: Basics- Tail Risk Hedging for Defense 25
Formal Derivation of Portfolio Hedges Using Factor Hedges 30
Rolling Tail Hedges 32
Benchmarking Tail Risk Management 37
Cash Versus Explicit Tail Hedging 43
Chapter 3 Offensive Tail Risk Hedging 51
A Model to Compute the Value of Tail Hedging 56
Model Calibration 57
Chapter 4: Active Tail Risk Management 71
Creating a Long History 78
Active Monetization Rules 84
Chapter 5: Indirect Hedging and Basis Risk 93
Quantifying Basis Risk 95
Hedge Matching at the Attachment Point 98
“Soft” Indirects: Comparing Puts versus Put Spreads 104
Basis Risk from Correlated Asset Classes 107
Chapter 6: Other Tail Risk Management Strategies 129
Tail Risk Hedging versus Asset Allocation in a Multimodal World 129
The Hedging Value in Trends and Momentum 134
A Look at the Risks and Rewards of Costless Collars 138
Variance Swaps and Direct Volatility-Based Hedging 141
Dynamic Hedging 146
Chapter 7: A Behavioral Perspective on Tail Risk Hedging 153
Narrow Framing and Tail Risk Hedging 154
Pricing of Put Options on a Standalone Basis 161
Multiple Equilibria and Expected Returns on Tail Hedges 165
Precommitment and Procyclicality 169
Chapter 8: Tail Risk Hedging for Retirement Investments 179
Chapter 9: Inflation and Duration Tail Risk Hedging 193
Hedging at the Money Inflation versus Inflation Tails 195
Tail Hedging Realized Inflation versus Inflation Expectations 198
Inflation Dynamics and Inflation Spikes 202
Framework for Inflation Tail Hedging 210
Benchmarking Inflation Tail Hedges 211
Pricing of Inflation Options 212
Options on CPI 212
Options on the Breakeven Inflation Rate 215
Indirect Inflation Tail Risk Hedging and Basis Risk 217
Pricing of Tail Interest-Rate Swaptions 219
Indirect Hedges 221
Example of Gold Options as Proxy Tail Hedge 222
Notes 225
Bibliography 231
Index 235
"TAIL RISKS" originate from the failure of mean reversion and the idealized bell curve of asset returns, which assumes that highly probable outcomes occur near the center of the curve and that unlikely occurrences, good and bad, happen rarely, if at all, at either "tail" of the curve. Ever since the global financial crisis, protecting investments against these severe tail events has become a priority for investors and money managers, but it is something Vineer Bhansali and his team at PIMCO have been doing for over a decade. In one of the first comprehensive and rigorous books ever written on tail risk hedging, he lays out a systematic approach to protecting portfolios from, and potentially benefiting from, rare yet severe market outcomes.
Tail Risk Hedging is built on the author's practical experience applying macroeconomic forecasting and quantitative modeling techniques across asset markets. Using empirical data and charts, he explains the consequences of diversification failure in tail events and how to manage portfolios when this happens. He provides an easy-to-use, yet rigorous framework for protecting investment portfolios against tail risk and using tail hedging to play offense. Tail Risk Hedging explores how to:
- Generate profits from volatility and illiquidity during tail-risk events in equity and credit markets
- Buy attractively priced tail hedges that add value to a portfolio and quantify basis risk
- Interpret the psychology of investors in option pricing and portfolio construction
- Customize explicit hedges for retirement investments
- Hedge risk factors such as duration risk and inflation risk
Managing tail risk is today's most significant development in risk management, and this thorough guide helps you access every aspect of it. With the time-tested and mathematically rigorous strategies described here, including pieces of computer code, you get access to insights to help mitigate portfolio losses in significant downturns, create explosive liquidity while unhedged participants are forced to sell, and create more aggressive yet tail-risk-focused portfolios. The book also gives you a unique, higher level view of how tail risk is related to investing in alternatives, and of derivatives such as zerocost collars and variance swaps. Volatility and tail risks are here to stay, and so should your clients' wealth when you use Tail Risk Hedging for managing portfolios.
PRAISE FOR TAIL RISK HEDGING:
"Managing, mitigating, and even exploiting the risk of bad times are the most important concerns in investments. Bhansali puts tail risk hedging and tail risk management under a microscope--pricing, implementation, and showing how we can fine-tune our risk exposures, which are all crucial ways in how we can better weather our bad times." -- ANDREW ANG, Ann F. Kaplan Professor of Business at Columbia University
"This book is critical and accessible reading for fiduciaries, financial consultants and investors interested in both theoretical foundations and practical considerations for how to frame hedging downside risk in portfolios. It is a tremendous resource for anyone involved in asset allocation today." -- CHRISTOPHER C. GECZY, Ph.D., Academic Director, Wharton Wealth Management Initiative and Adj. Associate Professor of Finance, The Wharton School"Bhansali's book demonstrates how tail risk hedging can work, be concretely implemented, and lead to higher returns so that it is possible to have your cake and eat it too! A must read for the savvy investor." -- DIDIER SORNETTE, Professor on the Chair of Entrepreneurial Risks, ETH Zurich