Should You Buy or Sell Tail Risk Hedges? A Filtered Bootstrap Approach

Abstract

The 2008 financial crisis has spurred investors to wonder about adding tail risk hedges to their portfolios. However, the cost of these hedges can often be a deterrent. As a consequence, many financial institutions have tried to develop cost-effective products for investors who wished to protect against tail risk. In particular, dynamically buying protection, i.e. selling a previously bought hedge when its market value is high enough, seems to remarkably reduce the cost of being protected. Some academicians and practitioners have long argued that investors shall instead sell tail risk hedges, so to cash in their substantial premia. Thus, in order to understand if there is an optimal approach to tail risk protection, we have looked at five competing strategies which are differently involved with tail risk hedges, and by relying on a semiparametric approach based on filtered bootstrap we have compared their return distributions. We show that there can hardly be a unique strategy suitable for all investors. For instance, our results suggest that selling protection and waiting till the maturity of the hedge can easily outperform a strategy which also sells the hedge but buys it back before this expires. This solution, however, probably suits those investors that, rather than hedging against tail risk, are actually ready to be more exposed to tail events, in order to boost portfolio returns. Conversely, dynamically buying protection may indeed answer the needs of those investors who are willing to hedge against tail risk in a cost-effective manner.

Keywords: Tail Risk Hedging, Risk Management, Option Pricing, Bootstrap, GARCH

JEL Classification: C14, C15, G10, G11, G12