TAIL RISK HEDGING by Vineer Bhansali


555bb47fb69057e-261x361.jpg Author Vineer Bhansali
Isbn 9780071791755
File size 15MB
Year 2014
Pages 272
Language English
File format PDF
Category economics



 

Tail Risk Hedging Disclaimer This publication contains information obtained from sources believed to be authentic and highly regarded. Reprinted material is used with permission, and sources are indicated. Reasonable effort has been made to publish reliable data and information, but the author and publisher cannot assume responsibility for the validity of all materials or for the consequences of their use. Certain information contained herein may be dated and no longer applicable; information was obtained from sources believed to be reliable at time of original publication, but not guaranteed. This views contained herein are the authors’ but not necessarily those of PIMCO. Such opinions are subject to change without notice. This publication has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The author or PIMCO may or may not own or have owned the securities referenced and, if such securities are owned, no representation is being made that such securities will continue to be held. This material contains hypothetical illustrations and no part of this material is representative of any PIMCO product or service. Nothing contained herein is intended to constitute accounting, legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. This publication contains a general discussion of tail risk portfolio management; readers should be aware that all investments carry risk and may lose value. The information contained herein should not be acted upon without obtaining specific accounting, legal, tax, and investment advice from a licensed professional. Tail Risk Hedging Creating Robust Portfolios for Volatile Markets VINEER BHANSALI New York   Chicago   San Francisco   Athens   London Madrid   Mexico City   Milan   New Delhi   Singapore   Sydney   Toronto Copyright © 2014 by Vineer Bhansali. All rights reserved. Except as permited under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. ISBN: 978-0-07-179176-2 MHID: 0-07-179176-0 The material in this eBook also appears in the print version of this title: ISBN: 978-0-07-179175-5, MHID: 0-07-179175-2. eBook conversion by codeMantra Version 1.0 All trademarks are trademarks of their respective owners. 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For my parents This page intentionally left blank Contents Foreword by Mohamed El-Erian xi Introduction xv Acknowledgments xix Chapter 1 Introduction to Tail Risk and Tail Risk Management 1 Lessons Learned Distressed Liquidation and Failure of Diversification 1 18 Chapter 2  Basics: Tail Risk Hedging for Defense 25 Formal Derivation of Portfolio Hedges Using Factor Hedges Rolling Tail Hedges Benchmarking Tail Risk Management Cash Versus Explicit Tail Hedging 30 32 37 43 Chapter 3  Offensive Tail Risk Hedging 51 A Model to Compute the Value of Tail Hedging Model Calibration 56 57 Chapter 4  Active Tail Risk Management 71 Creating a Long History Active Monetization Rules 78 84 vii viii Chapter 5  Indirect Hedging and Basis Risk Contents 93 Quantifying Basis Risk Hedge Matching at the Attachment Point “Soft” Indirects: Comparing Puts versus Put Spreads Basis Risk from Correlated Asset Classes 95 98 104 107 Chapter 6  Other Tail Risk Management Strategies 129 Tail Risk Hedging versus Asset Allocation in a   Multimodal World The Hedging Value in Trends and Momentum A Look at the Risks and Rewards of Costless Collars Variance Swaps and Direct Volatility-Based Hedging Dynamic Hedging 129 134 138 141 146 Chapter 7  A Behavioral Perspective on Tail Risk Hedging 153 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 154 161 165 169 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 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 195 198 202 210 211 212 212 215 Contents Indirect Inflation Tail Risk Hedging and Basis Risk Pricing of Tail Interest-Rate Swaptions Indirect Hedges Example of Gold Options as Proxy Tail Hedge ix 217 219 221 222 Notes 225 Bibliography 231 Index 235 This page intentionally left blank Foreword 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. xi xii Foreword 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 mistakes. 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 Foreword xiii 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. Mohamed El-Erian CEO and Co-CIO of PIMCO This page intentionally left blank Introduction 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, xv xvi Introduction 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. Introduction xvii 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 xviii Introduction 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. Vineer Bhansali Newport Beach, CA Fall 2013 Acknowledgments 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. xix

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

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