Macro approaches to portfolio tail risk hedging
Ian Penrose
Funds and Advisory
8 November 2012
For institutional and professional investors only. For information only. Not for further distribution or distribution to retail
investors. This document contains limited information about the strategy. Further details are available on request.
Speaker
Ian Penrose
Vice President – UK Distribution
Funds and Advisory
Barclays Investment Bank
Ian.penrose@barclays.com
020 7773 6919
3 | Tail Risk Hedging | November 2012
Contents
Defining tail risk
Looking at returns distribution in equity markets, what type of risks can
trigger a ‘tail risk’ event and why you should hedge
Hedging tail risk
Looking at ways of minimising the impact of tail risk on portfolios through
scenario analysis, selecting the best instruments at the best times and
selecting the most relevant data
Conclusions
Tail risk is hard to hedge, both long- and short-term solutions exist. A
methodical macro approach can help reduce impact of tail risks on
portfolios, sometimes benefitting from such events
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What is tail risk?
 Tail risks are extreme events which translate into financial market moves
of at least three standard deviations from their mean
S&P 500 index returns vs. Normalised S&P 500 returns¹
“Tails” of the
returns distribution
___________________________
1.
S&P 500 index data from 1 Jan 1984 to 30 November 2011. Source: Barclays, Bloomberg. Any prediction or data on past performance,
modelling or back-testing is no indication of future performance
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Tail risk and why it matters
Javier Estrada in his paper “Black Swans and Market Timing: How not to generate
Alpha” finds that if an investor in the Dow Jones Industrial Average over its history:
 Missed best 100 days would have reduced terminal wealth by 99.7%
 Avoided the 100 worst days would have increased terminal wealth by more than
43,000%
Various market indices 1996 – 2011 with ‘one-off’ crises circled
Asian crisis
TMT bubble bursts
Credit crunch
Euro debt crisis
___________________________
Source: Barclays, Bloomberg. Any prediction or data on past performance, modelling or back-testing is no indication of future performance
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The hedging dilemma for long-term investors
Volatility itself is very volatile. Over the long term, the cost of hedging may be too high a
price to pay. A simple buy-and-hold strategy may dampen returns rather than enhance
returns
Volatility has a tendency to ‘cluster’
VIX index from 2006 to 2012
___________________________
S&P 500 index data from Jan 1984 to Sep 2012. VIX index data from Jan 2006 to Sep 2012
Source: Barclays, Bloomberg. Any prediction or data on past performance, modelling or back-testing is no indication of future
performance
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Example of the cost of hedging
One traditional strategy for hedging tail risk is to create an ‘overlay’ of out-the-money put
spreads (80-90%) on the S&P 500 index. However, over the long term, the cost of rolling
dampens returns
A rolling put spread strategy
Performance
120
110
100
90
80
70
Sep-11
Jul-11
May-11
Mar-11
Jan-11
Nov-10
Sep-10
Jul-10
May-10
Mar-10
Jan-10
Nov-09
Sep-09
Jul-09
May-09
Mar-09
60
Date
Put Overlay
___________________________
Source: Barclays, Bloomberg. Any prediction or data on past performance, modelling or back-testing is no indication of future performance
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Why is tail risk hedging difficult?
Σ
The problem is too much information,
too fast
Information is growing
exponentially. Data is increasing at a
compound annual rate of 60%
Ω
√
€
The Economist Special Report on
Managing Information, February 2010
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¢
Oil price
Knowledge is increasingly
specialised. A true understanding of
medicine is impossible for one person,
for example. A 2004 study suggested
that in epidemiology alone it would
take a doctor 21 hours a day just to
stay current in the field
$
Data has become complex and intrinsically linked
Tail risk hedging
becomes more
complex with
increasing factors
Geopolitical Risk
US Interest
Rates
China
Interest
Rates
US GDP
EM Interest
Rates
EU Interest
Rates
China GDP
UST 10-YR
Energy
EM GDP
US Inflation
EU GDP
Precious
Metals
EM Inflation
China
Inflation
US Trend
Growth
EU Inflation
Industrial
Metals
EM Trend
Growth
China Trend
Growth
US Money
Supply
EU Trend
Growth
EM Money
Supply
China Money
Supply
Agriculture
EU Money
Supply
One strategy doesn’t fit all
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Identifying types of tail risk
There are various types of risks that can lead to a tail risk event, for example:
Financial
Risk
Risk associated with market risks, such as moves in interest
rates, foreign exchange, default risks etc…
Systematic
Risk
An event, perhaps a geo-political one, which affects a large
number of assets in a portfolio.
Idiosyncratic
Risk
A specific risk affecting a small number of assets. For example
a group of workers striking.
Liquidity
Risk
The risk that a given security cannot be traded fast enough
given a widening of bid-offer spreads. Thin liquidity can lead to
extreme market moves.
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Some hedges are more equal than others…
Picking the right instrument/asset is not always trivial.
US equity volatility is generally the most liquid and widely used. However, it may not
always be the best hedge available at the time
Vstoxx outperformed Vix when Europe was source of volatility
___________________________
Source: Barclays, Bloomberg. Any prediction or data on past performance, modelling or back-testing is no indication of future performance
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Tail risk hedging – qualitative approach to risk
management
Identify tail risk events and
likelihood with research
Deepening eurozone crisis, China hard
landing, oil spike shock
Quantify impact on
different asset classes
Assess expected impact on equities, FX,
credit etc…
Identify most
appropriate instruments
Hedge effectiveness vs liquidity, ability to
realise gains, counterparty risk
Construction of hedge
strategy
Execution
Passive, systematic or fully active
approach
Best execution
But what instrument do we use?
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A plethora of hedging instruments and tools
Example of hedging toolkit available in the market
Asset
Equity
Put spread
Volatility
overlay
VIX options
Variance
Best-of put
Rates
Receiver
Libor caps
Sonia-libor
Swaption
Rates
Credit
FX
Other
CDS Indices CDS options
Forward
swaps
CDS index
Non-cyclical
Swap
cyclical CDS govt. bonds
Basis swaps
Gold options ‘Black Swan’
Oil curve
Property
swaps
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Hybrid
Financial risk
Most financial based risks can be hedged with swap spreads
In March 2011, swap spreads hardly reacted to the Japanese earthquake (non-financial risk)
European swap spreads and VIX
___________________________
Source: Barclays, Bloomberg. Any prediction or data on past performance, modelling or back-testing is no indication of future performance
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Systematic risk
Systematic risk will most probably affect a variety of assets in a portfolio. Very often it is
followed by a large rise in correlations within and among asset classes. In this case
equity volatility may well be the best hedge (other than long correlation hedges)
VIX index in 2008 global financial crisis
Greek CDS during debt crisis (2011)
___________________________
Source: Barclays, Bloomberg. Any prediction or data on past performance, modelling or back-testing is no indication of future performance
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Idiosyncratic risk
Idiosyncratic risk can be hedged with individual CDS
BP plc CDS levels in 2010 in midst of gulf of Mexico oil spills (summer 2010)
___________________________
Source: Barclays, Bloomberg. Any prediction or data on past performance, modelling or back-testing is no indication of future performance
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Liquidity risk
In extreme scenarios, liquidity risk can lead to a credit crunch. Some of the most efficient
hedges to liquidity risks lie in money markets
Libor-OIS spreads during liquidity crunch of 2008
Lehman Brothers
collapse
___________________________
Source: Barclays, Bloomberg. Any prediction or data on past performance, modelling or back-testing is no indication of future performance
18 | Tail Risk Hedging | November 2012
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Barclays approach to tail risk hedging
– identifying tail events…
Credit
spread
Euro sovereign
spread
Equity market
volumes
Equity market
skew
Heightened market fear
Scheduled
significant
announcement
High probability of
unscheduled
announcement
Equity short/
long ratio
EUR short/
long ratio
No market fear
No action taken
Investment committee
Hedge portfolio risk
before announcement
Hedge portfolio risk
immediately
4 investment
committee members
must be present at the
decision meetings
Remove hedge as
market fear subsides
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Tail risk hedging – It does work!
Risk Managed Global Macro strategy vs. MSCI World in bull market and sell-off
___________________________
Source: Barclays, Bloomberg. Any prediction or data on past performance, modelling or back-testing is no indication of future performance
20 | Tail Risk Hedging | November 2012
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A practical approach to tail risk hedging
For long-term investors, exposure to an active global macro strategy together with a small weighting in
a long volatility fund can mitigate the cost of hedging whilst still delivering reduced portfolio volatility
A global macro strategy combined with European volatility
Indexed performance
115
110
105
100
95
90
85
Portfolio
Sep-12
Aug-12
Jul-12
Jun-12
May-12
Apr-12
Mar-12
Feb-12
Jan-12
Dec-11
Nov-11
Oct-11
Sep-11
Aug-11
Jul-11
Jun-11
May-11
Apr-11
Mar-11
Feb-11
Jan-11
Dec-10
Nov-10
80
MSCI World Index
___________________________
Source: Barclays, Bloomberg. Portfolio: 75% global equity represented by MSCI World Index, 20% Barclays Capital Radar Fund E share class,. 5% Vstoxx.
Data on past performance, modelling or simulations is no indication of future performance. Assumptions or estimates used in any simulation are
available upon request. Actual results may significantly differ from the simulated results being presented.
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Conclusions
We believe that tail risk hedging is anything but trivial. It is as much about
economic and financial analysis as filtering data and having 24-hour trading
systems in place.
Short-term hedging requires rigorous analysis of the best instruments and tools.
Long-term hedging can be costly, but there are various ways of cheapening it.
It is very hard to have a perfect hedge, and often enough it is not possible to
think about all possible tail risk scenarios:
“There are known knowns; there are things we know we know. We also
know there are known unknowns; that is to say we know there are some
things we do not know. But there are also unknown unknowns – the ones
we don’t know we don’t know.”
– US Secretary of Defense Donald Rumsfeld
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For institutional and professional investors only. For information only. Not for further distribution or distribution to retail investors
Thank you. Any questions?
Ian Penrose
Vice President – UK Distribution
Funds and Advisory
Barclays Investment Bank
Ian.penrose@barclays.com
020 7773 6919
23 | Tail Risk Hedging | November 2012
For institutional and professional investors only. For information only. Not for further distribution or distribution to retail investors
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Copyright Barclays Bank PLC, 2012 (all rights reserved).
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For institutional and professional investors only. For information only. Not for further distribution or distribution to retail investors