Tail Risk Hedging

Bernd Scherer

Let us casually define tail risk hedging as a strategy to avoid extreme outcomes. In the author’s view there are three methods to achieve this outcome with varying degrees of certainty.

1. Scenario optimisation. Given that tail risk hedging looks at scenarios adverse to a given portfolio, we can interpret this as an application of scenario optimisation (see Chapter 13) to explicitly incorporate tail risk into the portfolio construction process. Loosely speaking, this means adding assets, options or investment strategies that, in normal times, display large basis risks with a given “core portfolio”. However, in not so normal times that basis risk increases considerably and these assets (displaying significant tail correlation) start to work as a hedge. We need scenario optimisation, as this tail dependence is lost in mean–variance optimisation. Examples of investments of this kind are volatility-(fixed income or equities) and trend-following strategies. More generally, the financial engineer would look for assets that pay out well if a given portfolio is stressed. Alternatively, scenario optimisation could be used to generate portfolios that have little tail risk to start with.