Reduction of Interim Risk Through Options: An Analysis of Maximum Drawdown

Peregrine Securities, 2012

28 Pages Posted: 21 Apr 2016 Last revised: 28 Apr 2016

See all articles by Anthony Seymour

Anthony Seymour

University of Cape Town (UCT)

Florence Chikurunhe

Peregrine Securities

Emlyn James Flint

Legae Peresec; Department of Actuarial Science, University of Cape Town

Date Written: March 2, 2012

Abstract

Traditional risk measures such as standard deviation and CVaR are properties of the distribution of returns over a specified investment horizon. Because such fixed holding period analysis is relatively easy, and because derivative contracts are fixed-term products, the analysis of derivative strategies is normally conducted for a fixed horizon. Investors are, however, also likely to be concerned with changes in the value of an asset or portfolio at all times during the life of the contract. A more dynamic analysis is clearly desirable. Maximum drawdown is a path-dependent quantity that has emerged as a means to express interim risk. However, partly because of modelling complexities, maximum drawdown is often quoted as a single number based on the historical performance of a portfolio. This is potentially very misleading and ignores the analytic richness which can be derived from this measure. In this work we emphasise the fact that maximum drawdown is a random quantity with an associated distribution of possible values. An analysis of future maximum drawdown distributions is carried out in which the distributions are generated by means of Monte Carlo simulation. Using this technology we are able to report on a range of characteristics of the drawdown statistic for a given portfolio or instrument. The impact of hedging instruments is investigated and it is shown that strategies in which an index is hedged with a put option or a put spread exhibit significant reductions in the magnitudes of potential maximum drawdowns. This demonstrates the value of options in controlling dynamic risk over the entire term to expiry.

Keywords: Interim risk, maximum drawdown, option hedging

JEL Classification: C15, C61, G11

Suggested Citation

Seymour, Anthony and Chikurunhe, Florence and Flint, Emlyn James, Reduction of Interim Risk Through Options: An Analysis of Maximum Drawdown (March 2, 2012). Peregrine Securities, 2012. Available at SSRN: https://ssrn.com/abstract=2765931 or http://dx.doi.org/10.2139/ssrn.2765931

Anthony Seymour

University of Cape Town (UCT) ( email )

Private Bag X3
Rondebosch, Western Cape 7701
South Africa

Florence Chikurunhe

Peregrine Securities ( email )

21 Main Road
Claremont
Cape Town, Western Cape 7700
South Africa
+27117227551 (Phone)

HOME PAGE: http://www.peregrine.co.za

Emlyn James Flint (Contact Author)

Legae Peresec ( email )

15 Cavendish Street
Claremont
Cape Town, Western Cape 7700
South Africa
27117227556 (Phone)

HOME PAGE: http://www.legaeperesec.co.za

Department of Actuarial Science, University of Cape Town ( email )

Actuarial Science Section, University of Cape Town
Private Bag X3, Rondebosch
Cape Town, Western Cape 7701
South Africa
+27 21 650 2475 (Phone)

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