The Value of Tail Risk Hedging in Defined Contribution Plans: What Does History Tell Us

Abstract

Hedging against tail events has been forcefully advocated in the aftermath of recent global financial crisis. Whether this is beneficial to long horizon investors like defined contribution (DC) plan participants, however, has been subject to criticism. We conduct historical simulation since 1928 to examine the effectiveness of active and passive tail risk hedging using OTM put options for hypothetical DC plan investors with 20 years to retirement. Our findings show that the cost of tail hedging exceeds the benefits for a majority of investors during the sample period. However, for a significant number of simulations, hedging result in superior outcomes relative to an unhedged position. Active hedging proves beneficial when investors confront several panic-driven periods characterized by short and sharp market swings over the investment horizon. Passive hedging, on the other hand, only dominates when investors encounter an extremely rare event like the Great Depression when markets go into deep and prolonged decline.

Keywords: Tail risk, Active Hedging, Options, Monetization, Risk management