Tail Hedging Strategies

Abstract

This article introduces an algorithm for tail risk hedging and compares it to other existing methods. This algorithm adjusts the exposure level based on a measure of tail risk obtained by applying Extreme Value Theory (EVT) to estimate Conditional Value at Risk (CVaR). This method is applied to the S&P 500 and MSCI Emerging Markets equity indexes between 2001 and 2015 and its performance is compared to cash and options based tail hedging strategies. The cash based methods are shown to significantly increase risk adjusted returns and reduce drawdowns, while the options based strategy suffers a decrease in performance from 2003 on due to the increase in cost of puts with respect to calls after that date. The tail hedging technique presented in the article is fully investable as its turnover is limited; additionally it can replace long/short equity hedge funds for investors who do not have access to alternative investments.

Keywords: Equity Markets, Tail Risk, Extreme Value Theory (EVT), Dynamic Asset allocation, Value at Risk (VaR), Expected Shortfall (ES), Conditional Value at Risk (CVaR), Maximum Drawdown,Managed Volatility, Risk Management, Risk Control Index, Options, Quantitative Strategies

JEL Classification: C00, G00