In the recent period between 1980 and 2010,

TRADING FEAR AS AN ASSET CLASS

there have been several “left-tail” events as
shown in the below table, far more than
Executive Summary anticipated by the left tail of the distribution.
These events have eroded the value of the
The Eurozone debt crisis has been the focus of
portfolio long term investors.
the investment world for over a year. We look
at this debt crisis and see how investors can Why are we talking about this today?
hedge against “very unlikely” Black Swan events In the aftermath of the 2008 crisis, financial
relating to sovereign debt. Tail risk hedging is a markets world over are still in the process of
concept that is quickly catching on, and sells recovery, albeit at different stages. With no clear
side firms are busy packaging these strategies sense of direction, markets like the US and
for their clients. In this article, we first examine Europe are still fighting fears like the double
the growing market for, and concept underlying dip, stimulus pull back and default on sovereign
tail risk hedging. We then link this concept with debt. For investors therefore, the desire to
the debt crisis in the Eurozone. Lastly, we hedge left tail events is a rational response to
suggest a few simple tail hedges for the coming the not so unlikely extreme events as exhibited
year 2011. by the historic data.
Introduction: What is tail risk?
Investors tend to diversify their exposure across
asset classes in order to minimize their portfolio
risk. This logic however discounts the
possibility of the world markets collapsing.
However, diversification can‟t handle the risk of
markets collapsing to the extent represented by
the “thin” tails in the assumed log-normal
distribution of the returns.
Under normal market conditions, most likely
Source: PIMCO
returns are concentrated in the bulge near
centre of the distribution. The tails at the The chart below demonstrates this risk by
extreme ends represent events that are highly showing the peak-to-trough drawdown of the
improbable. Tail risk defines the risk posed by US equity market since 1926. The recent crisis
such events. These events are usually triggered led to a 50% drawdown.1
by a severe economic or financial crisis and
tend to rapidly spread across the global markets,
causing a spiral of declines affecting the broad
spectrum of investments. Analysis of the
returns of equity markets over a period of a few
decades shows that these tails are fatter than
what are predicted by normal distribution.

Source: SSgA, S&P
Probable tail risk events in the next couple of
months include a double dip in growth; an asset
price bubble in China and a debt default in
Japan and/or in PIIGS or any other European
country.
The Growing market for Tail Hedges
An article on Bloomberg referred to fear as
being the „hottest new product‟ on the street.
The fear of extreme events, no longer deemed
to be as improbable as depicted by the bell
shaped curve, is creating a demand among
investors for instruments to hedge themselves
against such risk. The fact is that investors are
becoming all too aware that they have been
underestimating the likelihood of “very unlikely
to occur events.” These events need not only be
related to sovereign debt defaults or corporate
bankruptcies. They could stem from physical
improbabilities – like the collapse of British
Petroleum‟s oil rig Deepwater Horizon in the
Gulf of Mexico that cost the company $30 bn
and cost several fishermen their monthly catch.
The cost of testing the failed „blowout
preventers‟ would have been minimal in
comparison to both the original cost of the rig
and to the $30bn loss it happened to cause.
In fact, Columbia Professor Rajiv Sethi opines
that tail risk hedging could be related to the
concept of the „Winner‟s Curse,‟ more
commonly used in auction theory. Making
above normal profits by not bearing the costs
of hedging against disasters could give you the
appearance of winning – till the point the fat tail
actually lashes out at you.2
Discussed in “The Black Swan: The Impact of
the Highly Improbable” by Nassim Nicholas
Taleb after its increasing popularity among
investment professionals, tail risk hedging
strategies are now increasingly being regarded as
an integral part of any comprehensive
investment portfolio more so post the 2007-
2008 crisis.
PIMCO has a fund that offers investor‟s
protection against market declines of more than
15%. Morgan Stanley strategists estimate
demand for hedges against such cataclysms
helped drive as much as a fivefold increase,
during the last quarter, in trading of credit
derivatives that speculate on market volatility. 3
Deutsche bank maintains an index ELVIS
(Equity Long Volatility Investment Strategy,
Bloomberg: DBVELVII) that rises with the
volatility that investors price into variance
swaps on the S&P 500. Citi Portfolio Solutions,
headed by former Indiana Pension Fund
employee John Liu, is a unit of Citigroup
dedicated to developing and managing tail risk
strategies for institutional clients.4
The fact that dedicated units addressing the
black swan phenomenon are mushrooming
across the financial playground is evidence
enough that investors are now catching on to
the concept. In fact strategists at Goldman
Sachs says that investors are in fact over paying
for derivatives that hedge these extreme risks,
while under hedging risks of more probable
events.5 The growing popularity has caused
prices of out-of-the-money (OTM) puts and
sovereign Credit default swaps rise, making tail oct) dec) (%)
risk hedging an expensive game – no longer a
Belgium 128.9 219.8 70.4
very “cheap protection.”
The Eurozone Debt Crisis and fear of Tail Spain 229.1 347.7 51.8
Events Germany 39.0 59.1 51.7
Recently, Portugal completed a successful bond
Netherlands 45.7 62.8 37.4
auction. While counter intuitive in the light of
recent events in PIIGS (Greece and Ireland in France 79.3 107.3 35.2
particular), this does at some level confirm Table 1: Worst quarterly performances - percentage change
beliefs regarding the unlikely hood of Eurozone
nations defaulting on debt. Even though yields Nor is Europe the only region which has been
in the PIIGS have peaked, the spreads are wide, facing the debt issue. Dubai had a case of tail
and Germany openly unhappy with the euro event relating to its debt situation is late 2009.
situation, the possibility of a default and PIMCO was advising selling protection on
subsequent disintegration of the Eurozone is Japanese sovereign debt in October 2010. 7
still a distant thought. However, for an investor
Put Rush 2007-2010
in European debt, a strategy could be to hedge 20
against this highly improbable tail end event. SPX
Implied vol difference

15 SX5E
Sivan Mahadevan, global head of equity and
credit derivatives strategy at Morgan Stanley, 10
says that trading in those options that are used
to gamble on price swings in benchmark 5
European credit-default swap (CDS) indices
rose fivefold from January to June 2010. An 0
ever rising portion of these trades are also Mar/07 Mar/08 Mar/09 Mar/10
speculative bets on very low probability events.
Securities houses have sold out-of-the-money Figure 1: Volatility premium in puts over calls (last 3 years)

protection against debt default by countries

outside the PIIGS cluster – including France Put Rush 2010 - Eurozone Debt Fears
and the United Kingdpom. CDS spreads on 10
SPX
Implied vol difference

French debt (on Jan 7, 2011) were at 110bps – 8 SX5E

that‟s greater than spreads of Thailand (100bps)
6
and Brazil (107bps) and same as that of Mexico!
Credit rating agency Fitch says that this is 4
because investors are using CDS for hedging
2
against fat tail events related to French credit
that may arise due to linkages with the 0
periphery Eurozone countries.6 Oct/09 Jan/10 Apr/10 Jul/10 Oct/10

Country 5-yr Mid 5-yr Mid Change Figure 2: Effect of Eurozone crisis on volatility premium in
bps (1st bps (31st puts over calls
A measure of market fear is the relative
difference in priced-in volatility of OTM puts
and OTM calls of same delta. When fear rules,
the price of puts should increase relative to
calls. This is similar, qualitatively, to option
skew. We examined the difference in implied
volatilities in 25 Delta Puts and 25 Delta calls
on the S&P 500 and Eurostoxx 50 over the
2010 period to see the reaction to news
regarding the Eurozone debt crisis.
As is evident, put buying was the order of the
day post May 2010, when the concerns about
the quality of debt in Greece and the other
PIIGS countries began to escalate. It was only
by late September did this difference in put-call
implied volatilities start its downward trend, as
investor sentiment seemed to indicate that a full
blow debt crisis was unlikely and that Europe
had enough muscle to eventually pull out. For
the sake of comparison, we can also look at the
same graph over a longer period of 2007-2010
and see the spike that occurs post the Lehman
collapse.
Our top tail hedges for 2011
The very idea of a black swan event is that it is
unpredictable. So we make no attempt to assign
probabilities to any cataclysmic events for 2011.
However, we propose to suggest a few events
that investors can hedge against and a few
simple strategies for the same
One of the tail events that we recommend
hedging against is the appreciation of Chinese
yuan. The pressure on Chinese government has
been increasing over the past few years,
especially from US, to allow its yuan to
appreciate vis-à-vis the USD. On June 19, 2010,
People‟s Bank of China made a statement that it
would allow for a more flexible exchange rate 8.
It was highly appreciated by all but external
criticism has begun again. The general
consensus is that the Chinese government
wouldn‟t give in to the external pressures. But,
even the internal pressures are mounting with
inflation increasing and unrest amongst the
labourers. Appreciation of yuan will help
Chinese government to make its oil and other
imports cheaper and contain inflationary
pressures.9 To hedge against this risk, we
recommend buying a deeply out-of-money put
option on Chinese H-shares. If the Chinese
yuan appreciates, prices of H-shares is expected
to crash as the Chinese exports (which are the
primary driver of its economy) will become less
competitive and suffer high losses. Put option
with a strike of 8000 (which is roughly 40% out
of money with spot being around 13000) and
expiring in December, 2011 can be bought at a
premium of just 0.2% and hence presents a
perfect example for a cheap protection against a
tail event of high appreciation of Chinese
yuan.10
The relatively speedy recovery of the US
compared to the Eurozone could be another
tail event for 2011. Eurozone has been fighting
the rising yields on sovereign debt of PIIGS, in
turn adversely impacting the EUR. However, in
light of the recent successful auction of
Portuguese bonds, the short term concerns
surrounding the weaker Eurozone economies
have been abated. US simultaneously has been
trying to boost growth in the economy post the
2007-08 crisis. Despite QE2, the consumer
demand continues to remain sluggish. At this
point, the recovery of European markets ahead
of US seems likely. However, for an investor
with a significant exposure to European debt,
hedging against the risk of an unexpectedly
quick recovery of US markets vis-à-vis Europe
might be rational. This risk can be hedged
effectively and cheaply by buying a significantly
out-of-the-money put option on EURUSD.
The 30 delta Dec‟11 Put currently trades at
2.7% with IV of 14.49%
For a party with significant exposure to debt in
Europe, a significant deterioration in the
sovereign debt situation is worth protecting
against. Assuming that most countries spreads
will widen in such a case, we pick any one
PIIGS nation say Italy. The 5y CDS spread on
13 Jan 2011 was 213bps. We suggest that the
hedger buy Italy protection, and to reduce
costs, sell protection on US CDS (44bps on
same date). The assumption here is that PIIGS
spreads will widen significantly more than US
spreads in such an event. This pair trade can
also serve speculation purposes.

-Megha Goyal, Puneet Gupta, Umang Mittal

1
Solutions for managing Tail Risk by Ric Thomas, State Street Global
Advisors:
http://www.ssga.com/library/exchng/Solutions_for_Managing_Tail_
Risk_Ric_Thomas_10.18.10CCRI1288278044.pdf
2
http://rajivsethi.blogspot.com/2010/06/on-tail-risk-and-winners-
curse.html
3
http://www.bloomberg.com/news/2010-07-20/pimco-sells-black-
swan-protection-as-wall-street-profits-from-selling-fear.html
4
http://www.csmonitor.com/Business/The-Reformed-
Broker/2010/0825/The-Wall-Street-Journal-advises-tail-risk-
hedging.-But-should-you
5
http://www.creditflux.com/Issuers/2010-06-14/Sovereign-tail-risk-
is-haunting-corporate-spreads-says-Goldman/
6
http://ftalphaville.ft.com/blog/2011/01/07 /452046/
7
http://www.pimco.com/Pages/PIMCO% 20Asia-
Pacific%20Cyclical%20Outlook%20Oct %202010.aspx
8 Retrieved Jan 16, 2011 from NY Times:
http://www.nytimes.com/2010/06/20/business/global/20yuan.html
9 Retrieved Jan 16, 2011 from Bloomberg news:
http://www.bloomberg.com/news/2010-11-13/u-s-pushes-china-
for-yuan-appreciation-before-hu-s-january-visit-to-obama.html
10 Retrieved Jan 16, 2011 from Hong Kong Exchange site:
http://www.hkex.com.hk/eng/ddp/Contract_Details.asp?PId=6