Dynamic Tail Risk Hedging 102727748

Dynamic Tail Risk HedgingMay 3, 2010Arne Staal Systematic Strategies | IPRS

2011 PORTFOLIO MANAGEMENT CONFERENCE

PLEASE SEE ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 21

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Conditional Tail Risk: The Known ‘Unknowns’ and the Unknown ‘Unknowns’• Tail risk is typically defined as low-probability ‘extreme’ moves in asset values• Conditional Tail Risk is relatively predictable, however …• Unpredictable extreme losses are the most severe type of tail risk

Monthly S&P 500 Tail Risk Predicted by Rolling Normal Distribution

Source: Barclays Capital

5% VaR events happen 5.2% of the time since 1985

Realized losses can be much larger than expected

Monthly Returns (%)

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Tail Hedging ApproachesTail Event Characteristics

Tail Risk Characteristics and Hedging Approaches

• Macro/systemic shocks that lead to large negative returns across asset classes

• Volatilities rise, absolute correlations increase sharply

• Flight-to-quality: investors flee to perceived safe haven assets and currencies

• Liquidity squeeze

• De-risk the portfolio, purchase flight-to-quality instruments

• Approximate hedging: invest in strategies and asset classes that are negatively correlated to tail risk

• Dynamic portfolio protection

• Explicit hedging: purchase option-like hedging instruments

Decreasing C

ost

Increasing Protection


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Outline

• Shaping the higher order distributions of a return profile depends on preferences, costs, capacity, etc.

We consider two situations to highlight tail hedging issues and approaches:I. Approximate Hedging: Tail Risk Hedging Overlays for Balanced Portfolios

• Is tail hedging different from asset allocation?• How to choose and size approximate hedges• A (dynamic) diversified minimum shortfall hedge overlay for a benchmark portfolio

II. Explicit Hedging: Tail Risk Hedging as a Systematic Trading Strategy• Tail risk in the FX carry trade • Shaping the hedged carry payoff distribution with options• Tail hedging as an alpha opportunity

There is no unique tail risk hedge for all strategies and portfolios

Tail Risk Hedging Overlays for Balanced Portfolios

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Diversification versus Tail Hedging

• Traditional method of reducing risk is to hold diversified portfolios (across instruments and across asset classes)• Traditional diversification can break down in the tails

• Tail hedging can be explicitly incorporated into allocation/optimization frameworks…

But• While there is no explicit cost of hedging through portfolio allocation, there is always an

implicit cost since allocation to an attractive asset may be reduced to reduce risk• Requires high-dimensional tail risk models and complicated optimization techniques

Therefore • Hedge tails through a post-allocation ‘overlay’ approach

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Asset Class Diversification Is Not Risk Diversification

Asset Allocation or Hedging?

Volatility Risk Diversification Is Not Tail Risk Diversification

• Traditional portfolios are characterized by skewed risk profiles

• Alternative allocation mechanisms can give very different risk results

• Asset allocation has its limits as a tail risk mitigation tool


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Equal (Variance) risk portfolio weights

Volatility contribution (%)

95% Expected Shortfall contribution (%)

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Hedging Overlays: Minimum Risk ApproachTail risk instruments should be selected in the portfolio so that the ‘stress beta’ is lower than the ‘normal beta’

Minimum Risk Hedging

( )Hp RRRiskMin ⋅− ββ

• Traditional symmetric hedging approaches aim to neutralize both positive and negative movements

• Tail risk hedging should focus on reducing extreme risks, not negative returns and volatility in general

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Sizing the Hedge: A Beta for Every Occasion

• Objective: Minimize the variance of the hedged position

• Traditional betas are widely used but do not target tail properties and treat losses and profits symmetrically

• Useful if distributions are normal

• Objective: Minimize the downside semi-variance of the hedged position

• Downside betas target losses explicitly• Useful if distributions are skewed

• Objective: Minimize the expected shortfall of the hedged position for a given confidence level (VaR)

• Tail betas explicitly target tail co-movement and expected size of returns on hedging instrument (convexity)

• Useful if distributions are skewed and fat-tailed

Traditional Beta

Downside Beta

Tail Beta

β

β

β


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Why Tail Betas?

• Tail betas explicitly target two criteria for a good hedge:

• Tail betas can be used as a criteria to select best cost/impact instruments in an intuitive way

• Tail betas apply to nonlinear, as well as linear instruments, strategies, and portfolios

• Techniques such as quantile regressions give good results for approximate hedges and allow for dynamic modeling of tail betas

]Portfolio Hedged Episode Tail|Hedgeon Return []PortfolioHedgedEpisodeTail|Portfolioon Return [

EE=β

Convexity Tail Co-movement

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Hedging Instruments for a 40/10/50 Portfolio

• Long equity volatility, SPVXMP:

• A Cross Asset Momentum Strategy:

We consider two strategies as tail hedging instruments for a 40/10/50 benchmark portfolio to minimize the monthly average loss below 4% (approx. 5% portfolio VaR)

37.0Tail,22.0 == ββ

14.0Tail,21.0 == ββ

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40/10/50 Benchmark Portfolio TR SPVXMP ER Cross Asset Momentum Strategy ERSource: Barclays Capital

Portfolio and Hedging Instruments

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Hedging a 40/10/50 Portfolio With (Dynamic) Tail Betas

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40/10/50 Benchmark Portfolio TR40/10/50 + 14% SPVXMP 40/10/50 + 14% SPVXMP + 37% Momentum40/10/50 + dynamic shortfall rule

Tail Hedging Performance


Tail Beta hedging approaches reduce downside risk

2001-current Mean S.d. ES below -4% Drawdown40/10/50 Benchmark Portfolio TR 3.1% 9.2% -7.1% 33.2%40/10/50 + 14% SPVXMP 3.8% 7.2% -6.1% 17.6%40/10/50 + 14% SPVXMP + 37% Momentum 4.3% 7.1% -6.2% 13.8%40/10/50 + dynamic tail beta 6.7% 6.4% -4.6% 10.4%

Barclays Capital,

Tail Risk Hedging as a Systematic Trading Strategy

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The FX Carry Trade

• Positive long-run excess performance but significant tail risk• Short volatility strategy: Carry performs poorly during periods of high volatility and

risk aversion

FX Carry is one of the most popular investment strategies amongst FX investors

• Tail Risk in FX Carry is realized over very short periods: between September and October 2008, an investor with long exposure to AUD/JPY lost 33% in a little under four weeks

FX Carry versus FX VolatilityThe FX Carry Trade

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Russian crisis (Aug 98)

Asian crisis (Oct 97)

Bear Stearns sale (Mar 08)

Lehman bankruptcy (Sept 08)

WTC attack (Sept 01)

Tech bubble bursts (Mar 01)

ERM crisis (Sep 92) Peso crisis

(Dec 97)

US Subprime losses reported (Jun 07)

Greek bond crisis (Apr 10)

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Carry index

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Carry strategy (lhs) Implied vol index


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Understanding FX Carry Returns

• G-10 passive carry basket consists of nine US dollar pairs and five euro crosses. Pairs are rebalanced monthly, with long positions in the high yielding currencies, funded by short positions in the low yielding currencies

We can isolate the carry portfolio risk by decomposing the performance into the pure carry component and movements in spot rates

Decomposition of Returns

Movement in spot rates is the dominant source of tail risk

Yield component provides steady returns

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Spot component Yield component Carry return

Indexed performance

Source: Bloomberg, Barclays Capital

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FX Carry with Tail Hedge

Option Overlays: Shaping the Downside with Long Puts

Hedged FX Carry Performance

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Carry strategy ATMF 25 delta 10 delta

Carry

ATMF 25 delta

10 delta

1st half (1999-2005)Annualised return 4.0% 1.7% 2.6% 3.1%Volatility 2.9% 2.4% 2.7% 2.9%Sharpe ratio 1.37 0.71 0.97 1.10

2nd half (2006 - 2011)Annualised return -0.1% 1.8% 1.3% 0.4%Volatility 6.7% 3.8% 4.7% 5.7%Sharpe ratio -0.01 0.48 0.27 0.07

Full sample (1999-2011)Annualised return 2.5% 1.7% 2.1% 2.2%Volatility 4.6% 3.0% 3.5% 4.1%Sharpe ratio 0.55 0.59 0.60 0.53

Max drawdown -14.4% -4.4% -6.8% -11.0%Skewness -1.64 1.00 0.34 -0.46% profitable months 0.66 0.52 0.54 0.59Max monthly loss -8.1% -2.1% -2.8% -5.1%

Carry with options

Hedge tail risk in the carry trade by rolling 1m put options on the investment currencies


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Option Overlays: Improving the Upside with Short Calls

• Long put is struck ATMF to provide robust downside protection• Call strike set to reflect the trade-off between premium earned and the expected cost of

the payout

We consider a long put, covered call strategy that cheapens the cost of the tail hedge and provides income in times of distress

)](1[ Upsidetttt CFK σλ ⋅+±⋅=

K = strike, F = forward rate, C = yield, σ = upside spot volatility and λ = volatility factor

Hedging the downside

Selling the upside

σ

A simple Strike Setting Rule:

• Receive the full amount of pairwise carry available

• Set the strike as a function of the expected upside potential in spot rate movements

Dynamic Strike Setting


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Dynamic strike: standard deviation

Dynamic strike: Upside deviation

Carry strategy

FX Carry with Tail Hedge

The Alpha in Tail Hedging

FX Carry Performance

Incorporating dynamic tail hedging in the FX carry trade isolates the alpha

Carry

0.25 0.5 1 1.5 21st half (1999-2005)Annualised return 4.0% 0.6% 1.1% 1.7% 2.0% 2.1%Volatility 2.9% 1.1% 1.2% 1.6% 2.0% 2.2%Sharpe ratio 1.37 0.57 0.85 1.07 1.02 0.96

2nd half (2006 - 2011)Annualised return -0.1% 1.9% 2.1% 2.4% 2.4% 2.4%Volatility 6.7% 2.0% 1.9% 2.2% 2.6% 3.0%Sharpe ratio -0.01 0.92 1.09 1.10 0.94 0.78

Full sample (1999-2011)Annualised return 2.5% 1.1% 1.4% 2.0% 2.2% 2.2%Volatility 4.6% 1.5% 1.5% 1.9% 2.2% 2.5%Sharpe ratio 0.55 0.70 0.93 1.07 0.98 0.87

Max drawdown -14.4% -1.9% -1.2% -1.3% -1.7% -2.4%Skewness -1.6 0.2 0.4 0.5 0.6 0.8% profitable months 0.7 0.6 0.6 0.6 0.6 0.5Max monthly loss -8.1% -1.6% -1.1% -1.1% -1.1% -1.0%

Carry with options overlayDynamic strike (lambda)


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FX Carry with Overlay Decomposition

Intuition: Decomposing FX Carry with Options Overlay

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Overlay Spot Yield Carry Plus Option Overlay

Indexed performance

Provide cheap insurance when investment spot rates are trending up

Provide income from call selling and put payoffs during unwind episodes


Concluding Remarks

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Concluding Remarks

Tail risk hedging is a complex problem that requires tailored solutions:• Identify risks/risk factors• Explicit versus approximate hedging• Hedging instruments’ effectiveness and costs• Hedging approaches

The potential for better investment performance is substantial:• Approximate tail hedging in a risk measurement framework can improve portfolio return

characteristics• Tail betas could be used to ‘warehouse’ tail risk

• Explicit tail hedging overlays can be designed to improve overall investment results of individual strategies and asset classes• Understanding the return distribution allows for more effective targeting of payoff

preferences

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Analyst Certifications and Important DisclosuresAnalyst Certification(s)I, Arne Staal, hereby certify (1) that the views expressed in this research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report.Important DisclosuresFor current important disclosures regarding companies that are the subject of this research report, please send a written request to: Barclays Capital Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer to https://ecommerce.barcap.com/research/cgi-bin/all/disclosuresSearch.pl or call 212-526-1072.Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Barclays Capital may have a conflict of interest that could affect the objectivity of this report. Any reference to Barclays Capital includes its affiliates. Barclays Capital and/or an affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). The firm's proprietary trading accounts may have either a long and / or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers. Where permitted and subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel to determine current prices of fixed income securities. The firm's fixed income research analyst(s) receive compensation based on various factors including, but not limited to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the profitability and revenues of the Fixed Income Division and the outstanding principal amount and trading value of, the profitability of, and the potential interest of the firms investing clients in research with respect to, the asset class covered by the analyst. To the extent that any historical pricing information was obtained from Barclays Capital trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document. Barclays Capital produces a variety of research products including, but not limited to, fundamental analysis, equity-linked analysis, quantitative analysis, and trade ideas. Recommendations contained in one type of research product may differ from recommendations contained in other types of research products, whether as a result of differing time horizons, methodologies, or otherwise.

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Important Disclosures (continued)This publication has been prepared by Barclays Capital, the investment banking division of Barclays Bank PLC, and/or one or more of its affiliates as provided below. It is provided to our clients for information purposes only, and Barclays Capital makes no express or implied warranties, and expressly disclaims all warranties of merchantability or fitness for a particular purpose or use with respect to any data included in this publication. Barclays Capital will not treat unauthorized recipients of this report as its clients. Prices shown are indicative and Barclays Capital is not offering to buy or sell or soliciting offers to buy or sell any financial instrument.

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Important Disclosures (continued)This material is distributed in Saudi Arabia by Barclays Saudi Arabia ('BSA'). It is not the intention of the Publication to be used or deemed as recommendation, option or advice for any action (s) that may take place in future. Barclays Saudi Arabia is a Closed Joint Stock Company, (CMA License No. 09141-37). Registered office Al Faisaliah Tower | Level 18 | Riyadh 11311 | Kingdom of Saudi Arabia. Authorised and regulated by the Capital Market Authority, Commercial Registration Number: 1010283024.

This material is distributed in Russia by Barclays Capital, affiliated company of Barclays Bank PLC, registered and regulated in Russia by the FSFM. Broker License #177-11850-100000; Dealer License #177-11855-010000. Registered address in Russia: 125047 Moscow, 1st Tverskaya-Yamskaya str. 21.

This material is distributed in India by Barclays Bank PLC, India Branch.

This material is distributed in Singapore by the Singapore branch of Barclays Bank PLC, a bank licensed in Singapore by the Monetary Authority of Singapore. For matters in connection with this report, recipients in Singapore may contact the Singapore branch of Barclays Bank PLC, whose registered address is One Raffles Quay Level 28, South Tower, Singapore 048583.

Barclays Bank PLC, Australia Branch (ARBN 062 449 585, AFSL 246617) is distributing this material in Australia. It is directed at 'wholesale clients' as defined by Australian Corporations Act 2001.

IRS Circular 230 Prepared Materials Disclaimer: Barclays Capital and its affiliates do not provide tax advice and nothing contained herein should be construed to be tax advice. Please be advised that any discussion of U.S. tax matters contained herein (including any attachments) (i) is not intended or written to be used, and cannot be used, by you for the purpose of avoiding U.S. tax-related penalties; and (ii) was written to support the promotion or marketing of the transactions or other matters addressed herein. Accordingly, you should seek advice based on your particular circumstances from an independent tax advisor.

© Copyright Barclays Bank PLC (2011). All rights reserved. No part of this publication may be reproduced in any manner without the prior written permission of Barclays Capital or any of its affiliates. Barclays Bank PLC is registered in England No. 1026167. Registered office 1 Churchill Place, London, E14 5HP. Additional information regarding this publication will be furnished upon request.

Dynamic Tail Risk Hedging 102727748

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