Tail Risk Hedging and Regime Switching

40 Pages Posted: 17 Oct 2011 Last revised: 5 Aug 2016

See all articles by Markus Huggenberger

Markus Huggenberger

University of Mannheim - Department of Risk Theory, Portfolio Management and Insurance

Peter Albrecht

University of Mannheim - Department of Risk Theory, Portfolio Management and Insurance

Alexandr Pekelis

University of Mannheim - Department of Risk Theory, Portfolio Management and Insurance

Date Written: August 4, 2016

Abstract

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

Huggenberger, Markus and Albrecht, Peter and Pekelis, Alexandr, Tail Risk Hedging and Regime Switching (August 4, 2016). Asian Finance Association (AsianFA) 2015 Conference Paper. Available at SSRN: https://ssrn.com/abstract=1945303 or http://dx.doi.org/10.2139/ssrn.1945303

Markus Huggenberger (Contact Author)

University of Mannheim - Department of Risk Theory, Portfolio Management and Insurance ( email )

Schloss
D-68131 Mannheim
Germany

Peter Albrecht

University of Mannheim - Department of Risk Theory, Portfolio Management and Insurance ( email )

Schloss
Mannheim, D-68131
Germany

Alexandr Pekelis

University of Mannheim - Department of Risk Theory, Portfolio Management and Insurance ( email )

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