One of the final presentations during Day 2 of CBOE’s Risk Management Conference teamed up Ari Paul, CFA, Portfolio Manager at The University of Chicago Office of Investments and Rebecca Cheong, Head of Americas Equity Derivatives Strategy, UBS Securities. They separately discussed aspects related to Risk Hedging Frameworks: Governance Concerns and Equity Derivative Strategies.
Paul began listing sources of “wrong-way risk” as he is advocating for tail risk protection. I specifically found a couple pieces of interest. He noted that asset correlations spike to 1.00 in a crisis. This can result in the beta of even a diversified portfolio rising. Due to investment performance fees related to hedge funds we often suffer 100% of downside, but only get 80% of the upside.
Another statement I found particularly insightful was that expected investment returns are highest after a crisis. I think we can acknowledge that it is usually the hardest time to buy and early 2009 was noted as a time that many investors actually reduced equity exposure before the equity market took off to the upside. He takes this thought and points out that tail risk protection provides cash during a crisis when investors may be stuck with illiquid assets.
Cheong discussed cross asset hedging with a focus on SPX and VIX. She compared SPX puts versus VIX calls in multiple ways highlighting what works better and when. I found her statement that hedging with SPX for the second 10% of a 20% move is a cheap and effective trade. She noted that it is rare we get more than a 20% drop in the equity market that is not followed by a rebound. Therefore, she’s OK with not being hedged against a drop beyond the 20% drop.
On the VIX side she highlighted is a favorite of mine, the Short VIX 1 x 2 Call Spread. A generic payout for this trade appears below, however she mentions that to utilize this structure you should be prepared to trade around it. Specifics involve selling a 2 month low strike call and purchasing two 2 month higher strike calls.
Finally, she noted that the best tail risk hedge combines systematic hedging with logic. The calls this being tactically systematic which involves buying protection when it is cheap in addition to systematically having tail hedge positions on.