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For my parents
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Foreword by Mohamed El-Erian
Chapter 1 Introduction to Tail Risk and Tail
Distressed Liquidation and Failure of Diversification
Chapter 2 Basics: Tail Risk Hedging for Defense
Formal Derivation of Portfolio Hedges Using Factor Hedges
Rolling Tail Hedges
Benchmarking Tail Risk Management
Cash Versus Explicit Tail Hedging
Chapter 3 Offensive Tail Risk Hedging
A Model to Compute the Value of Tail Hedging
Chapter 4 Active Tail Risk Management
Creating a Long History
Active Monetization Rules
Chapter 5 Indirect Hedging and Basis Risk
Quantifying Basis Risk
Hedge Matching at the Attachment Point
“Soft” Indirects: Comparing Puts versus Put Spreads
Basis Risk from Correlated Asset Classes
Chapter 6 Other Tail Risk Management Strategies
Tail Risk Hedging versus Asset Allocation in a
The Hedging Value in Trends and Momentum
A Look at the Risks and Rewards of Costless Collars
Variance Swaps and Direct Volatility-Based Hedging
Chapter 7 A Behavioral Perspective on Tail Risk Hedging
Narrow Framing and Tail Risk Hedging
Pricing of Put Options on a Standalone Basis
Multiple Equilibria and Expected Returns on Tail Hedges
Precommitment and Procyclicality
Chapter 8 Tail Risk Hedging for Retirement Investments
Chapter 9 Inflation and Duration Tail Risk Hedging
Hedging at the Money Inflation versus Inflation Tails
Tail Hedging Realized Inflation versus Inflation Expectations
Inflation Dynamics and Inflation Spikes
Framework for Inflation Tail Hedging
Benchmarking Inflation Tail Hedges
Pricing of Inflation Options
Options on CPI
Options on the Breakeven Inflation Rate
Indirect Inflation Tail Risk Hedging and Basis Risk
Pricing of Tail Interest-Rate Swaptions
Example of Gold Options as Proxy Tail Hedge
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Many astute and experienced professional investors will tell you that
today’s marketplace is, to use an old American expression, “not your
father’s Oldsmobile.” Quite a few investors are seeking to evolve their
approaches to keep up with changes on the ground, actual and prospective. Others have even decided to return funds to their clients rather
than try to invest in a world that that they no longer sufficiently understand, let alone feel able to predict accurately.
Major global economic realignments and material regulatory
changes are among the major reasons for today’s more fluid investment
landscape. But they are not the only ones.
Since the 2008 global financial crisis, most advanced countries
have faced persistent difficulties in delivering high economic growth
and sufficient jobs. With political polarization further limiting policy
responses, the largest economies have embarked on a prolonged period
of monetary policy experimentation that has seen central banks get
more and more deeply involved in markets as both referees and players.
Undeniably, central banks have consequentially influenced how
markets function, value securities, and allocate capital. And the deeper
they have been pulled into this hyperactive involvement, the less obvious the route of exit. Indeed, it is far from clear how and when central
banks will eventually be able to extricate themselves from what has
become an intense influence on risk positioning, liquidity, and pricesetting behaviors.
In such circumstances, investors are challenged to navigate several unprecedented and quite persistent disconnects. Whether it is the
deviation of market prices from underlying economic and corporate
fundamentals, or the more volatile and less predictable correlations
among traditional asset classes, the trade-offs and hand offs between
tactical and strategic positioning are no longer as straightforward as
they once appeared.
The bottom line is a simple but consequential one. If investors
wish to continue to generate superior long-term returns, they will have
to work harder, smarter, and somewhat differently.
To succeed, investors will need to construct global portfolios with
more agile alpha and beta engines, more forward-looking differentiation, and more resilient sizing of positions. Equally important, they will
also need to limit their vulnerability to severe downturns that threaten
to suddenly erase hard-gained returns and, judging from the insights of
behavioral finance, also increase the probability of subsequent portfolio
Portfolio diversification will remain a critical, necessary condition
for all this, but it may no longer be sufficient. As investors seek to position themselves for durable success, they will be challenged to think
more holistically about a distribution of potential outcomes with materially fatter tails.
For insights on these critical issues, including how to adapt risk
management approaches to today’s (and tomorrow’s) realities, investors would be well advised to look to Vineer Bhansali’s brilliant book.
Drawing on his pioneering and highly regarded work on the subject,
Vineer provides readers with valuable insights on the why, what, how,
and when of portfolio tail hedging.
The book’s added value is not limited to this already consequential
and timely objective. Drawing on thought-provoking work that Vineer
has delivered over the years, it also shows how a more holistic and
modern approach to risk management enhances the ability to exploit
temporary and reversible market dislocations.
As Vineer demonstrates well, smart tail hedging is about more than
just better addressing the consequential two-sided extremes of distributions. Properly designed and executed, it has the potential to place
portfolios in an improved position to exploit more consistently the
opportunities that are provided in the belly of the distribution.
Whether your emphasis is on return generation, risk mitigation, or
(hopefully) both, you will find Vineer’s book informative and actionable. Simply put, it is a must-read for those investors seeking to excel
consistently in what has become (and will remain) a highly fluid world.
CEO and Co-CIO of PIMCO
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The conceptual origin of this book goes back to many years before my
entry into finance. During one summer research project in physics at
Caltech, it became obvious to the young undergraduate that was me
that the “action,” so to speak, was not in the middle part of the distribution but in the tails. Over the years, research papers (on power
laws and fat tails) and popular books (on black swans) from all areas
of inquiry made it obvious that the time was ripe for low-probability,
high-severity events to assert their right to a proper analysis. And then,
of course, the mother of all recent crises happened in 2008, and tail
risk management entered the lexicon of investment management with
a speed and intensity yet unmatched.
For me personally, the practice of tail risk management goes back
to 2002, when an astute investor cherry-picked the tail risk management sleeve for a customized hedging portfolio. Despite the running
cost of the explicit option premia, it became immediately obvious that
by using a tail-hedging overlay at relatively low and finite cost, the
investor had achieved three objectives: (1) he could hold his investments in other skilled managers while hedging out the common market
tail exposure, (2) he could tune up or tune down the market exposure
according to his needs and the opportunity sets with liquid instruments, and (3) he had more predictability about the distribution of
returns; that is, he could plan his investment strategy ahead of the dayto-day implementation noise. These were clearly benefits, and in time,
the success with these new portfolio design elements attracted others
who embraced and implemented similar ideas.
This book is targeted to an audience familiar with the basics of
option pricing and trading. I made no effort to provide an exhaustive
exposition of option pricing models or theories, instead hoping that
an interested reader would chase them down on the Internet or via the
large number of books and papers now available. The target audience
is a mix of traders and portfolio managers who have a solid analytical
and quantitative tilt, though I have been told that some of the work
in this book as originally published has been used in MBA and CFA
classes. Most of the text is original or based on original work, so it is
hard to attribute individually to all the written and oral inputs of so
many that have gone into this book. But my thanks are due to all who
have influenced and continue to subliminally influence my ongoing
research and investments.
Chapter 1 lists a few major reasons for tail risk hedging and tail
risk management. These are reasons that both ex post and ex ante strike
me as valid for having tail risk hedging as an always-on (as opposed to
just-in-time) risk-management tool in the investment tool kit.
Chapter 2 introduces a simple and transparent framework based
on the core specifications of a tail risk management practice in terms
of risk exposures, attachment points, and costs. While many investors
approach tail risk management from many different angles, I believe
that this trinity of inputs clarifies what the investor is intending tail risk
hedging to achieve. Of course, this approach also highlights that the
three inputs have to satisfy simultaneously; that is, exposures, attachment levels, and costs cannot be arbitrary and unbound.
Chapter 3 flips over the tail risk coin and provides a detailed exposition of how tail hedges allow portfolios to be positioned more offensively, thus offering a mechanism to subsidize the cost of running such
a hedging program. In this way, tail hedging is not only risk-reducing
but also can be return-enhancing.
Chapter 4 discusses the value and techniques for active tail risk
management and monetization approaches. It is clear that tail hedging
using options in particular can be expensive from the perspective of
loss of value via time decay. I discuss how by managing the hedges as
nonlinear, time-decaying assets, one can optimize the value of a tailhedging portfolio.
Chapter 5 addresses indirect hedging using markets and instruments that are correlated with the direct hedging instruments. I define
and quantify basis risk and how to create a good tradeoff between cost
reduction of hedges and the probability of the hedge not delivering as
planned because of correlations failing to realize.
Chapter 6 discusses other strategic tail-hedging approaches, such
as dynamic asset allocation, “collars,” variance swaps, and alternative
betas. The ability to put all these approaches on a common platform
(of cost versus tail convexity) allows an investor to maximize the potential hedging gains in a truly multifaceted way. None of the discussion
is detailed enough for the reader who wants a deep dive, and I would
point them to the rich literature for these approaches.
Chapter 7 looks at tail hedging from a behavioral perspective.
Using models that rely heavily on Kahneman and Tversky’s prospect
theory, I approach the problem of tail hedging within the portfolio
context, the variation in the skew, and time inconsistency in tail hedging that leads eventually to the opportunity to tail hedge cheaply over
a market cycle.
Chapter 8 focuses on tail hedging for retirement accounts. The
investment behavior of participants close to retirement says a lot about
the implicit costs and benefits of tail hedging for their portfolios. With
a complex interaction of varying time horizons, risk tolerance, and the
underlying dynamics of the market, the retirement investment area is a
natural place for practical application of the principles discussed so far.
Finally, Chapter 9 discusses hedging of inflation and interest-rate
or duration tail risk. While most of the demand and supply of hedging
so far has been in the domain of equity-like risks, I believe that in the
years to come, the hedging of interest-rate and expected-inflation risk
will be key to the construction of robust portfolios.
This book was written over a period of many years, and I happily
concede that it is not complete in any form. Given a choice, I find it more
fun to think in terms of the core concepts rather than an encyclopedic
list of each and every alternative for tail hedging.
Realizing these limitations, to me this book is still a work in progress;
it will have achieved its interim goal if investors recognize some value in
the principles and are able to construct more robust investment portfolios for themselves.
Newport Beach, CA
This book would not have emerged without the collaboration of
numerous clients and colleagues. My understanding of portfolio management, investing, and risk management continues to be enhanced
daily by the fruitful discussions and analyses with so many.
I would, however, like to specially thank four individuals who
have been early collaborators on research on tail risk management as a
part of portfolio construction: Mohamed El-Erian, Josh Davis, Mark
Wise, and Bruce Brittain. A brief chat with Mohamed when he was
the CIO of Harvard management revealed a few months before the
financial crisis that we were independently thinking of financial tail
risks and efficient ways of hedging them. This resulted in collaboration
on asset allocation and tail risk hedging when he returned as CO-CIO
of PIMCO. Josh has been a collaborator and indeed co-originator of
many of the ideas in this book, particularly in Chapters 3–5. Mark and
I go back decades—first when I was his SURF student at Caltech and
then when we collaborated on papers relating to correlation matrices
and swap spreads under stresses and to optimization of portfolios with
higher moments. Finally, Bruce and his team have worked in connecting the dots that have helped tail risk hedging to become a unique new
business for PIMCO. I would also like to thank numerous unnamed
others who by their initial and in many cases continued skepticism
have pushed me deeper into understanding the dynamics of options
markets, rare events, and exploration of investors’ sometimes unexplainable behavior when it comes to taking catastrophic risk of ruin.
Author Vineer Bhansali Isbn 9780071791755 File size 15MB Year 2014 Pages 272 Language English File format PDF Category Economics Book Description: FacebookTwitterGoogle+TumblrDiggMySpaceShare “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 Download (15MB) Country Asset Allocation: Quantitative Country Selection Strategies in Global Factor Investing The End of Accounting and the Path Forward for Investors and Managers Hedge Funds, Humbled: The 7 Mistakes That Brought Hedge Funds to Their Knees and How They Will Rise Again Inside the House of Money Handbook of Financial Markets: Dynamics and Evolution Load more posts