A Discretionary Approach to Tail Risk Hedging

Angel Serrat

This chapter will present a framework to assess the efficacy of alternative approaches to tail risk hedging. We apply it to some of the more popular systematic tail hedging strategies and conclude that, with hindsight, most of them would have worsened the risk/return trade-off for any rational investor. In contrast, we argue that discretionary strategies that opportunistically pursue positively convex payouts across asset classes, when structured properly, can offer an efficient tail hedge.

Since the beginning of the 2000s, and especially after the 2007–09 crisis, financial market behaviour has been characterised by recurrent “tail events”, which we define as periods of synchronised downward correction in the valuation of global risky assets, generally associated with a sudden increase in risk aversion, a marked deterioration in financial conditions and drastic reduction in market participants’ ability to borrow. This behaviour is often triggered by events such as the Lehman crisis in September 2008 or the sovereign debt crises in the spring of 2010 in Greece and in the summer of 2011 in the Eurozone (for several examples, see Figures 7.1 and 7.2). In this chapter, we will not