An Introduction to Tail Risk Hedging

Andrew Rozanov and Ryan McRandal

The purpose of this opening chapter is to provide a basic introduction to tail risk hedging in the context of an institutional portfolio, and to set the stage for the rest of the book. We will touch on the reasons why tail risk hedging has become such a popular topic since the global financial crisis of 2007–09. We also discuss different types and sources of tail risk in financial markets, defining the specific segment that constitutes the focus of this book. We then consider some of the more typical arguments used against tail risk hedging and explain why we disagree with the sceptics. Finally, using a four-step procedure, we offer one possible roadmap that describes how institutional investors might want to think about the tail risks embedded in their portfolios, concluding with the concept of a “point of indifference” that is introduced here for the first time. This should provide an appropriate framework for the reader to engage with the rest of the book.

THE IMPACT OF THE CRISIS

In the wake of the global financial crisis of 2007–09, there has been a virtual explosion of investor interest in tail risk hedging strategies. Market practitioners were compelled to focus on this