Offensive Risk Management II: The Case for Active Tail Risk Hedging

Abstract

In a previous paper (Bhansali and Davis [March 2010]), we discussed one aspect of what we have called Offensive Risk Management – how using tail hedges in a portfolio might permit investors to allocate more capital to risk assets, while looking to mitigate the risk of large investment losses. We demonstrated that if the hedge is purchased at the right price, the portfolio with tail risk hedges may have a more attractive risk-return profile, ex-ante, than a buy-and-hold portfolio. We also mentioned that active monetization of hedges may provide liquidity that might be used to purchase cheap assets in periods of crisis, thus further improving the ex-ante long-term return potential of the portfolio; but we did not discuss monetization rules in detail. This paper addresses the second point and shows that indeed in the context of the 80-year history of the Standard and Poor's index, one can justify intuitive rules of thumb for monetization that are consistent with the cyclical behavior of the economy and the markets. We find it comforting that the ex-post analysis discussed in this paper is both complementary to our previous work, and produces common-sense results that an investor might want to apply in their offensively risk-managed portfolios.

Keywords: Tail Risk, Risk Management, Options

JEL Classification: C22