Tail Risk Hedging and Regime Switching
40 Pages Posted: 17 Oct 2011 Last revised: 5 Aug 2016
Date Written: August 4, 2016
We analyze hedging strategies that minimize tail risk measured by Value-at-Risk (VaR) or Conditional-Value-at-Risk (CVaR). In particular, we derive first-order conditions characterizing VaR- and CVaR-minimal hedging with futures in regime-switching models. Using cross-hedging examples, we theoretically and empirically demonstrate that tail-risk-minimal strategies can noticeably deviate from standard minimum-variance policies in the presence of crash regimes. In such examples, VaR- and CVaR-minimal strategies based on regime-switching models are able to attain additional tail risk reductions, which can be confirmed by nonparametric and extreme-value-theory-based methods. These results imply that the proposed methodology for tail risk management can cut losses during financial crises and reduce capital requirements for institutional investors.
Keywords: Value-at-Risk, Conditional-Value-at-Risk, regime-switching models, elliptical distributions, futures hedging
JEL Classification: G11, G32, C58
Suggested Citation: Suggested Citation