Tail Risk Hedging May2010

8/6/2019 Tail Risk Hedging May2010

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Pleaseseeimportantdisclosuresattheendofthisdocument.

DeutscheBankPensionStrategies&SolutionsisapartofGlobalMarketsInstitutionalClientGroup

Tail Risk Hedging: A Roadmap for Asset Owners

DeutscheBankPensionStrategies&Solutions

May2010

Wetookrisks.Weknewwetookthem.

Thingshavecomeoutagainstus.

Wehavenocauseforcomplaint.

RobertFrost

"Itisoftensaidthat[one]iswisewhocanseethingscoming.

Perhapsthewiseoneistheonewhoknows

thathecannotseethingsfaraway."

NassimTaleb


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Mounting Tail Risk Concerns

Followingthetraumaticeventsofthe lasttwoyears,riskand itsmanagementhavebecomethe

mostvisiblesubjectwithintheassetownerworld.Aspartofthemanagementoftherisk,tailrisk

hedginghastakencenterstage.

Thispaperaims toprovideaclear,stepbystepguide to theprocessofhedging tail riskacross

manyasset types.Wehopethat it isable toprovideusefulexamples,commonsensesolutions,

andadvantage/disadvantageanalysisofvariousapproaches.Wehavemadeeveryefforttomake

itscontentclear,concise,anduseful.AlthoughDeutscheBankGlobalMarketsdoesnotact ina

fiduciarycapacityandthisdocumentisprovidedforinformationalpurposesonly,wehopethatit

canserveasapositivesteptowardhelpingourclientsmakeinformeddecisions.

Pleasedonothesitatetocontactusifyouhavequestions.

KenAkoundiPensionStrategies&Solutions

GlobalMarketsInstitutionalClientGroup

Phone:2122505437

Email:[email protected]

JohnHaughPensionStrategies&Solutions

GlobalMarketsInstitutionalClientGroup

Phone:2122508970

Email:[email protected]

Defining Tail Risk

Tail risk is technicallya riskofaportfoliovaluemoveofat least three standarddeviations (3)

fromthemeanandismoreprobable(frequent)thananticipatedbyanormaldistribution.

However, the recent surge of interest in this topic has not remained limited to this precise

definition,butinsteadhasdriventheuseoftheterminologytorefertothepossibilityofgeneric

rare events. Since every dataset can be roughly characterized by a distribution (e.g., Normal,

Poisson) that is in turn characterizedbymean, standarddeviation,etc., identifying the specific

relevantdatasetisimportant.

Theemergentnebulousmeaningofthetermtailriskisnotentirelyinvalid,butneedbebetter

framed. Inthecontextofthisdocument,afunctionalmeaning isused: inessence,tailrisk isthe

riskthatalargemoveinaportfolioisgreaterthanwhatisimpliedbytraditionalriskmanagementtheories(withoutimplyinganexpectedseverityoftheevent,suchas3 or6).

With this framework,we thereforeuse the term tail riskhedging to refer to the creationof

positionswithinaportfoliothatarecreatedtoprotectagainstdownwardmarketmoves.


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Hedge Selection Process

Withthewidearrayoftailriskhedgesavailable,itisintegraltodevelopasystematicstrategyfor

selectingproducts and building a hedgeportfolio. There are three fundamental steps, each of

which presents a series of questions that have been formulated to help an asset ownersuccessfullynavigatethetailriskhedgingdecisionprocess.

1. Analysis:Beginswithareviewofportfolio factors/exposuresandadeterminationof the

desiredportfoliobehaviorandconstraints towhichahedgewouldbe subject.This step

includesdiscussionofhedgingparameterssuchasestimatedeventprobabilityandasset

classaswellassuitabilityandcosttoleranceanalysis.

o Whatarewehedging?Page3

o Activehedgingordiversification?Page4

o Whathedginginstrumentsmaybeappropriate?Page5

2. Synthesis: Involves hedge selection and bespoke solution construction, pretrade

monitoring,legalandoperationalreview,costanalysis,andexecution.

o Whatarethecostsofhedging?Page7

3. Monitoring:Monitoringincludesquantifiablereviewoftradeimpactandofthesuitability

of choosing to monetize or unwind instead of continuing to hold the hedge. The

supervision levelandmonitoringfrequencyrequiredwillalsoaffect instrumentselection.

Forexample, ifdailymonitoring isnecessary, then illiquidbespokesolutionsmaynotbe

ideal.

o Whataremymonitoringconstraints?Page8

For convenience,wehave created aTailRiskDecision Table (Table 3),which canbe foundon

page16*.

*SomehedgetypesmentionedinTable3arenotexplicitlydiscussedelsewhereinthepaper.Pleasecontactusto

discuss.


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What are we hedging?

Asset Hedging

Withaworkingdefinitionof tail risk inhand,anassetownermustdecideon thedegreeof

hedging desired. Is the hedge to be placed at the single instrument level (e.g., toomuch

Microsoftexposure), theme/sector level (e.g., toomuchexposure to tech),asset class level

(e.g., toomuch Beta to S&P 500), or portfolio level (e.g., toomuch exposure to equities)?

Usuallythis isthehardestquestion,but itsanswerbeginswithasimple lookattheportfolio

anditsmakeup.Itisassumedthatassetownershaveagoodunderstandingoftherisksintheir

portfolioeitherquantitativelywhichispreferredorqualitatively,whichismorecommonly

the case.For reference, averageDefinedBenefitportfolio allocations are roughly similar to

Table1below.

If the choice is made to hedge at the

assetlevel,whichisusuallythecase,then

the

first

decision

to

be

made

is

which

subset of the portfolio needs hedging;

the conclusion tends to be equities,

specifically S&P 500 equities because

they typically represent the largest

allocationwithin the portfolio and have

beenhistoricallyoneofthemostvolatile

andmosteasilyhedgible.Otherportfolio

subsets being considered by asset owners tobe hedge candidates include EAFE portfolios

(whichruntheriskofUSDrunup),inflation(whichimpactsbothfixedincomeandliabilities),

andsomerealassets(whichcouldbesusceptibletorealestatecollapse).

Liability Hedging

Amore complete analysis of hedging tail risks expands the assetonly paradigm to include

liabilities.Forexample,adeflationaryenvironmentiscripplingtopensionplansasdecreasing

ratesincreasethevalue(andcost)ofliabilities.Thiscanhaveatremendousnegativeeffecton

plansolvency,contributionrequirements,andfinancialreporting.Additionally,someinvestor

types,suchaspublicpensionsandendowments,oftenhave liabilitiestiedto inflation.These

typesofrisksshouldbe identifiedandanalyzedandappropriatehedgingsolutionsshouldbe

considered.

Europe,Australasia,FarEast

Table 1: Sample Defined Benefit Plan Allocation

Asset Class Target

Domestic Equity 40%International Equity 10%

Domestic Fixed Income 30%

International Fixed Income 2%

Private Markets (includes Hedge Funds) 10%

Real Assets (TIPS, Commodities, etc.) 5%

Cash 3%


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Active Hedging or Diversification?Withatargetportfoliosubsetinmind,

the asset owner must now decide

whethertopursueactivehedgingortodiversifyallocation inordertobroadly

decreaseportfolio risk. In the context

ofthispaper,activehedgingisdefined

as the act of adding positions that

neutralizespecificrisktypeswithinthe

portfolio, and diversification is an

income investment that lowers

portfolio riskdue to lowercorrelation

between asset classes. This decision

will

hinge

on

the

firms

constraints,

assetallocationguidelines(suchasthe

preexistence of a commodity

allocation), legislative or corporate

governance issues (for some plans,

derivativesareprohibited),liquidityofthehedgemarket(equitiesaregenerallymoreliquidthan

corporatecredit),andexpectedseverityoftailevent(e.g.3 or5 event).

Forexample, if theportfoliodoesnot

yet include commodity exposure, a

straightforwardmeanstodiversifythe

portfolio isbyeitheraddingapassive

commodity allocation via an index

such as Deutsche Banks flagship

commodityindexDBC,orviaanactive

managedfuturesallocationsuchasthe

DB MATRIX index. Historically,

commodity indices have had a low

correlation to the portfolio and

thereforerepresentagooddiversifier.

Managed commodity futures have

exhibited a negative correlation to equities and naturally increased diversification. In Table 2above, the correlationbetweenmanaged commodity futures andother asset classeshasbeen

showntobezerotonegative.

Theassetcorrelationmatrixshown inTable2wasconstructedusingBloombergmonthendclosingprices forthe

period duringwhich consistent data is available for each instrument:March 2006April 2010. The correlation of

instrumentswithdataextendingearlierholdroughlyconsistenttothecorrelationsinthetable.Whereapplicable,the

previousdaysclosingpricewasusedonholidays forwhichdatawasnotavailable, inorderto facilitatecorrelation

calculations.

USBonds(AGG)

Co

mmoditiesIndex

(DBC)

USR

ealEstate(VNQ)

Eur

ope,Australasia,

FarEast(EFA)

USL

argeCapStocks

(VV)

Inflation-protected

Treasuries(TIP)

Volatility(VIX)

ManagedCommodity

Fu

tures(DBMatrix)

US Bonds (AGG) 0.07 0 .31 0 .38 0 .27 0 .76 -0.28 0 .00

Commodities Index

(DBC)0.07 0.34 0 .55 0 .49 0 .45 -0.27 -0.02

US Real Es tate (VNQ) 0.31 0 .34 0.77 0 .84 0 .27 -0.47 -0.33

Europe, Australasia, Far

East (EFA)0.38 0 .55 0 .77 0.93 0 .39 -0.63 -0.15

US Large Cap Stocks

(VV)0.27 0 .49 0 .84 0 .93 0.34 -0.65 -0.25

Inflation-protected

Treasuries (TIP) 0.76 0 .45 0 .27 0 .39 0 .34 -0.26 -0.11

Volatility (VIX) -0 .28 -0 .27 -0 .47 -0 .63 -0 .65 -0 .26 0 .00

Managed Commodity

Futures (DBMatrix)0.00 -0.02 -0.33 -0.15 -0.25 -0.11 0.00

Table 2: Correlation Matrix

Chart 1: Equity/Volatility Relationship

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Although diversification is a valuable portfolio management tool, hedges may not hold their

characteristic correlation profiles under extreme market conditions. In order to hedge these

extremetailevents,anassetownercanchoose toactivelyhedge theportfolio.Forexample,an

assetownercanpurchaseprotectionagainstvolatilityspikes,whichhavefrequentlyoccurred in

conjunction with declining equity markets (see Chart 1

). At the trough of the 20082009downturn,theVIX index,ameasureofS&P500 indexshorttermvolatility,peakedat80.Atthe

timeofthiswriting,theVIXisinthelow30s,withacorrelationtoUSlargecapequitiesof0.65,

ascanbeseen inTable2.Note that this tablealsoshows that theVIXhasexhibitedhistorically

strongnegativeorlowcorrelationtotheotherassetclasses.

AlthoughdirectinvestmentsintheVIXaregenerallyexpensiveorfraughtwithbasis,theredoexist

many efficient methods for protecting against volatility spikes. These methods are addressed

furtherintheHedgeExamplessectiononpage11.

What hedging instruments may be appropriate?

Hedgevehicleselection isdependentonmany factors, themost importantofwhich iswhether

the firm isamanagerofmanagers,**orhas inhousehedging/overlay/trading rights,which in

legalparlanceisreferredtoasanInHouseAssetManagerorINHAM.

IftheassetownerisnotanINHAM,thendirecthedginginstrumentsmaynotbepermissibleand

allhedgingoroverlaysshouldbeperformedviaQualifiedPlanAssetManagers(QPAM),subjectto

anRFPprocess.

INHAM/QPAM

issues

notwithstanding,

the

selection

of

a

hedging

vehicle

depends

on

several

factors,listedbelow.

Are derivatives allowed in the portfolio?

Many plan sponsors currently do not directly trade derivatives in their portfolio, due to

portfolioguidelinesand/ortheindividualstatelawsthatgovernpublicplans.

Recently,asmarketshavegenerallybecomemoresophisticatedandliquid,pensionsandtheir

consultantshavebeguntoconsiderandadvocateforderivativesintheirportfolios.Thedesire

togainaccess tosomeassetclassesviaderivativeshasaidedacceptanceofderivatives,but

onlytoacertaindegree.Whileinvestment inmanagedfuturesor in long/shortequityhedgefunds have been accepted, pure option strategies and investment in illiquid assets are

generallystillshunned.Thecurrentregulatorypressureonderivativesisunlikelytoaffectplan

sponsorusageintheshort ormediumterm.

Chart1datacompiledfromVIXandVVdailyprices,aspublishedonBloomberg

**Manypensionplan sponsorsoutsource the specificassetmanagement functionand concentrate theireffortson

selectingthemanagersforeachassetclass.


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Is leverage allowed?

Many plan sponsors similarly limit the use of leverage within their portfolios. Although

leverage isnotwelldefined in thiscontext, for thoseplansponsorswhomaybe restricted

fromusingleverage,itisgenerallyacceptedthatleverageconsistsof: Directborrowingintheformofcreditfacilities(sometimespermissible)

Usingshortsaleproceedstofundlongpurchases

Embedded leverage that is inherent in certain financial products such as futures,

options,andstructuredproducts

Rulesandregulationsconcerning theseconceptsaregenerallystricter forERISAentitiesand

sometimeslessstrictlydefinedforsomeallocationbuckets(suchasisoftenthecaseforHedge

Fundinvestments).

Assetownersshouldconfirmandclarifyapplicablederivatives,leverage,andotherrestrictions

withtheirlegalcounsel.

What are the horizon and the expected rarity of the event to be hedged?

Plansponsorsneedalsodeterminetheoptimaltradehorizon.Thismustbeconsideredinthe

contextof theportfolioshorizon,whether itbe strategicor tactical,but ineithercase, the

implementationofthesolutionisdependentonthetypeandavailabilityofinstrumentexpiries

andmaturities.For instance: iftheselected instrument isanequityoption,adifferentsetof

considerationsapplythanifadirectindexinvestmentisselected.Inthecaseofequityoptions,

onemustconsiderexpiryof theunderlyingoptions (aswellasstructureand thenumberof

optionsrequiredtoachievethedesiredeffect),butindicesusuallydonothaveanexpiry.

Similarlyrelevantisoneofthemostspokenaboutcharacteristicsofstatisticaldistributions, .

Inessence,thelargerthenumberofsigma,themorerareaneventis(a6 eventismorerare

thana3 event).Dependingon themarket conditionsof theportfolio subset that isbeing

hedged,aneconomicdecisionabout hastobemadevisviscost(moreonthisabitlater).

Forinstance,ifanassetownerchoosestohedgeitsequitiesbook(S&P500)withvolatility,itcan

dosoviavarianceswaps,tailriskprotectionindices,orindexswaps.Moreinformationoneachof

theseisavailableintheHedgeExamplessectiononpage11.


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What are the costs of hedging?Mostofthefactorsmentionedintheprevioussectionsaffectoverallcost,whichisoftentheasset

ownersprimary consideration.Cost analysis isnot simple, andunderstanding the factors that

affectitisimportant.Thesefactorsinclude:

Timing: Inrelativelycalmmarkets,impliedvolatilityislow.ConsideroptionsontheCDX.IGindex(anindexlinkedto125investmentgradecorporatecredits):thecostofCDX.IGindexoptions,

whichispartiallycomprisedofvolatilitypremium,islesswhenthecreditmarketiscalmthanit

isinturbulenttimes.The20092010creditmarketrallyhascreatedmarketstabilitythatmay

presentagoodopportunitytopurchaseprotection.Assetownersneedtobeawareofmarket

timingcontextwhenplacingahedge.

Liquidity:Liquidity isameasureofmarketdepthandofhowquicklyandreasonablyanasset

canbeboughtorsoldwithoutsignificantlyaffectingthemarket.Variousassetsdifferintheirliquidity:S&P500indexconstituentstocks,withaheavytradingvolume,areforthemostpart

moreliquidthanthoselistedontheTorontoStockExchange.Usuallyathinnertradingvolume

demandsahighertransactioncost.ThisrelationshipisalsoprominentintheOverTheCounter

(OTC)vs.Exchangetradeddiscussion.

Horizon:Theperiodoftimeduringwhichahedgewouldneedtobeineffectisthehedgestimehorizon. This concept is closely tied to both the timing concept and to liquidity, and by

extension, longerdated solutions are frequently more expensive. That said, for some

instruments, a sufficiently long maturity/expiry may not be available. For longerterm

strategies,considerindexinvestments,whichhavenomaturity.Forashorterhorizon,options

on theVIXwhichextendexpirysevenmonths into the futuremaybemoreeconomically

appropriate.

Trade Size: Dependent on trade mechanics, trade size can either significantly increase orcategorically decrease transaction costs.When operating in the CDS market, for example,

largernotionalvaluecanaffectrelativeliquiditydramaticallyandincreasecost.Inthecaseofa

highlycustomizedstructuredsolution,largernotionalvalueallowsforeconomiesofscaleand

reducesperunitcost.

Funded vs. Unfunded Instruments: Amajordeterminant in thecostofahedgewillbe

whether

the

instrument

chosen

is

a

funded

or

unfunded

vehicle.

Products

can

be

fully

funded,

requireonlyasmallpremiumpayment,orinsomecasesonlyrequireaninitialmarginamount.

Wehave illustrated thisproperty inTable3(a),wherewerepresent thecashoutlayofeach

hedge instrument by employing a relativemeasure indicator ($ requires less cash outlay

than$$).

Structure Complexity:Asolutionmaybesimpleandcomprisedofonlyoneinstrument(e.g.,put option on the S&P 500) ormore complex and be created from a series of individual


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instruments(e.g.,optioncollaronS&P500).Oftenthesemorecomplexstructuresarecreated

todiffusecost,suchasinthecaseofanoptioncollaronS&P500,whichcaninvolvebuyinga

putoptionandoffsettingthecostoftheputbysellingacalloption.Thiskindofsolutionsheds

cost at the expense of some hedging efficiencies. In addition, there are some bespoke

solutionsthat increasestructuralcomplexity inordertoachieveaneconomicpurposesuch

asabespokecreditdefaultswapbaskettrade.Thistradewouldbesimilartobuyingprotectionon the CDX.IG index (which references 125 companies) except that the bespoke swap

referencesaninvestorpickedsubsetofcompanies(e.g.7080preferredcompanies).Typically

bespokesolutionssuchasthesearemoreexpensive.

Service Provider Factors: The following parameters affect the cost of any proposedsolution:

Scale: Largerproviders can affordmoreeconomiesof scale,especially if they are a

market maker. Those with a broad geographical reach can also leverage product

diversity,marketexpertise,andoperationalefficiencies.

Counterparty credit/rating:Morehighlyratedentities ability toborrow at a lower

costtranslatestopotentialsavingsfortheirclients.

What are my monitoring constraints?

Monitoringisobservationandevaluationbyasystemorperson.Beforeimplementingahedge,it

is critical to consider theoperationalburden causedby thenecessityofmonitoring thehedge.

Propermonitoringshouldaddresswhetherthehedgeisperformingasexpected,ensurethatitis

notnearingitsexpiry/maturitytimeframe,anddeterminewhethermarketconditionscallforthe

terminationoftheposition.Whendiscussingmonitoring,consider:

Frequency: In general, positions should be monitored as frequently as possiblebutmonitoring frequency must also be evaluated on a casebycase basis. For less liquid

instruments, dailymonitoringmay not be possible, as their reported price often does not

changeasfrequently.InthecaseofanassetownerthatisanINHAM,theappropriateexisting

tradingteamoftenincludesthistaskinitsresponsibilities.

Metrics: Severalmetricsmust be considered in order to ensure thatmonitoring efforts aresufficientlythorough:

Price/MarktoMarket: Change in price is themost important indicator of how an

instrument/strategyactsasahedge.

Volume:Asanimportantindicatorofliquidity,changesinvolumemustbemonitoredas diligently as changes in price. Past experience has shown that liquidity shrinks

dramaticallyduringextrememarketevents.

Efficiency: It is recommended to monitor hedge effectiveness and periodically

reevaluate assumptions. Simplemeasures such as total portfolio value or complex

measures such as ValueatRisk are widely held to be acceptable methods for

measuringefficiency.


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Tools:Assetowners should consider their technical limitationsor strengths in the contextofmonitoringtoensurethatmonitoringcanbeperformedproperly.

Price:Althoughmostpricing levelsarereportedbymarketdataservices,someasset

prices can only be obtained from broker/dealers. In the case of these assets, a

relationshipwithabroker/dealeriscritical.

Portfolio: Portfoliomonitoring tools tomeasure hedge effectiveness are available

commercially,oroften,serviceproviderscanoffer reportsor theuseofproprietary

portfoliomonitoringtoolsuponrequestbesuretoask.

Collateral: Aspects ofmonitoring collateral are also subject to specialized systems

oftenprovidedcommercially.

Collateral: Some instruments, such as swaps, require careful monitoring to ensure propercollateral calculation and exchange of credit/debit between counterparties. There are also

manyproductssuitable to tailriskhedging thatdonot require theexchangeofcollateral. If

collateralmonitoringisoperationallyimplausible,theassetownershouldconsideralternative

solutions.Custodybankscantypicallyprovidethismonitoringservice.

Counterparty:Itshouldberememberedthatcounterpartyriskcanquicklybecomeanissueina tailevent scenario.This consideration ismore relevant in the caseofhedges thatdonot

clearthroughanexchange,butassetownersmustbecognizantofnewsandhappeningsthat

may affect their counterparties adversely. The most straightforward ways to reduce

idiosyncraticcounterpartyriskistofacethemosthighlyratedcounterpartiesandtodiversify

counterpartyexposure.


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RisksBefore a solution is implemented, it is worthwhile for the asset owner to be aware of the

spectrumofrisksinherentintheirdecision.Theserisksaresummarizedforeachtypeofsolution

inTable3(b).Forexample,anequityoptioncollarhasequityrisk,nonlinearityriskbecauseitsa

collectionofderivatives,operational riskbecause itneeds tobe rolledbeforeoratexpiry,and

somecareerriskfortheCIO/decisionmakerifhedgesdramaticallyunderperformexpectations.

Relevantrisksinclude,butarenotlimitedto:

Market risk:Alsoknownas systemic risk, this is the risk that iscommon toanentiremarketsystem. The value of investmentsmay decline over a given timeperiod simply because of

economicchangesorothereventsthatimpactthemarketatlarge.

Non-linearity Risk: Potential losses on derivative positions that are due to a nonlinear

relationshipbetween thepriceof thederivativeand thepriceof theunderlying instrumentthatthederivativereferences.

Credit Risk: Potential losses associated with the ratings upgrade, ratings downgrade,restructuring,ordefaultofa referenceentity.Recovery rates in theeventofeachof these

influencecreditriskaswell.

Counterparty Risk:Therisktoeachpartyofacontractthattheircounterpartywillfailtofulfillits contractual obligations. Counterparty risk is a risk to all involved parties and should be

consideredwhenevaluatingasolution.The importanceofconsideringthisriskhas increased

in

the

wake

of

the

unexpected

failure

of

several

broker/dealers.

Operational Risk: Potential losses associatedwith the executionof an investors systems,processes,andpersonnel.This includes tradingrisk, fraudrisks, legalrisks,physicalrisk,and

environmentalrisks.Inthiscontext,operationalriskreferstotheriskinherentintheprocess

ofhedging(analysis,synthesis,andmonitoring),andthecomplexitiesthatresultfromhands

onmanagement.

Career Risk:LooselydefinedaspotentialforlossofprofessionalcredibilityoftheCIO/decisionmakerduetoanadverseoutcomeofhedgingdecisions.Anindividualwhofollowsareasoned,

conservativedecisionmakingprocessshouldbeabletodeflectcareerrisk.


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Hedge Examples

Asasupplement toTable3, includedherearebrief illustrationsofa fewstrategies thatcanbe

implemented toeffectivelyhedge tail risk scenarios tied to specificasset classes.Assetowners

shouldconsiderwhetheranystrategyisallowedorappropriatebeforeimplementing.

VarianceSwaps

TailRiskProtectionIndices

EquityOptionStrategies

CreditStrategies

InflationFloorAgreements

InflationHedge:EnergyIndices

ManagedFuturesIndices

SovereignRiskCommodityHedge

SovereignRiskRatesHedge SwapsonIndices

Variance Swaps

Avarianceswapisanoverthecounterfinancialderivativethatallowsonetospeculateonor

hedge risks associated with the magnitude of movement (volatility) of some underlying

product,suchasanexchangerate,interestrate,orstockindex.Inavarianceswap,twoparties

enteracontractonforwardrealizedvariance.Atmaturityitpaysthedifferencebetweenthe

realizedvarianceandthepreagreedvariancestrike. Varianceswapsprovidepureexposureto

the

underlying

price

volatility,

without

the

complication

of

delta

risk,

which

is

present

in

options.Theimplementationofvarianceswapsrequiresinhouseexpertiseinordertoanalyze

inclusionandsizinggivenaportfolio.

Tail Risk Protection Indices

Volatilitybased tail riskprotection indicesare rapidlybecomingapopular choiceasoverlay

equitytailriskhedges.DeutscheBanksELVIS index isonesuchexample.ELVISusesforward

varianceswaps toeffectivelygo longS&P500 impliedvolatility,whichavoids theotherwise

necessaryvolatilityriskpremiumembeddedinoptionprices.Historically,periodsofsevere

lossesintheequitymarkethavebeenmetwithupwardspikesinvolatility,qualifyingtheindex

asanappropriateandeffectivetailriskhedge.AddingDBELVISgrantsaportfoliosubstantial

downsideprotectionwhileminimizingcarryingcostsduringhealthymarketperiods.Contrary

tomanyotherstrategies,ELVISdoesnotrequireactivemanagementtomaintainprotection

which alleviates operational burden associated expiration/rollingand is structured in a

simpleandtransparentmanner.

DeutscheBanksEMERALDindexperformsinasimilarmanner,withadifferentstructure.DB

EMERALDseekstocapturereturnsbasedontheS&P500sdemonstratedtendencytomean


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12

revert during the course of a single week, essentially generating returns while providing

downside protection. The performance of the index is tied to the spread between daily

volatility and weekly volatility, which has displayed consistent negative correlation. DB

EMERALDsadvantagesaresimilartothoseofDBELVIS: lowcostofcarry,noneedforactive

management, simple and transparent structure, and efficiency in hedging equity risk. It is

important tonote thatboth indices relyon thepersistenceof thehistoricnegativeequityvolatilityrelationshiptoperformasanticipated.

Equity Option Strategies

Traditionalputoptionstrategiesareamong themoststraightforwardapproaches toactively

hedging equity risk, and are also among the most effective if implemented properly.

Historically, longdated 70% strike puts on the S&P 500 have been a popular choice, since

options are illiquid at strikesbelow 70%, and therefore generallymore expensive. Thisput

strategyiscomparativelycheap,moderatelyliquid,andeffectiveinseveremarketdownturns.

Operational

drawbacks

include

cost

volatility,

additional

fees

associated

with

rolling

the

position,andthenecessitytomonitorpositionsaroundexpiry/rollperiod.

Employing tailored option strategies involves combining puts and calls, and in some cases

overthecounter instruments, to develop a specific hedge profile. Put spreads and putcall

collarsarecreatedtodiffusecost.ConsideranoptioncollaronS&P500,whichinvolvesbuying

aputoptionandoffsetting thecostof theputbysellingacalloption.Thiskindofsolution

sheds cost, but at the expense of some hedging efficiencies. Additional features can be

structuredtoallowaninvestorflexibilitytotailorthehedgetoanyparticularmarketoutlook.

Relative to traditional put options, tailored option strategies are inherentlymore complex,

requiremorecarefulmonitoring,andcanbelessliquid.

Credit Strategies

Therearefourcredithedginginstrumentsthatarecommonlyavailable:

Creditdefaultswaps(CDS)onindividualissuers:Forexample,buyfiveyearprotectiononGE

default

CDSindices:CDX.IG(investmentgrade)andCDX.HY(highyield)arethemajoravailableindices

inUScorporatecredit.ThereisalsoaliquidlytradedindexthataddressesSovereignrisk.

OptionsonCDSindices:OptionsareavailableontheCDX.IGindex

Tranches(slicesofvaryingseniority)onCDSindices:TranchesareliquidonCDX.IGandCDX.HY

CDSon individual issuers isused toexpressabearishviewonorhedgeexposure tospecific

names, or sets of names (perhaps a sector). This approach is less appropriate for macro

hedgingortailriskhedgingexceptwhentheissueritselfisasystemicallyimportant/tailrisk

sensitive entity for example, buying protection on financials, insurance companies, and

sovereignshavebeenusedastailriskhedgesinthepast.


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13

ThemostliquidlytradedUSCDS index istheCDX.IG,whichreferences125investmentgrade

corporate credits. This is an active strategy that facilitates straightforward and transparent

exposuretotheCDSmarket.OptionsonCDSindicesallowinvestorstobuycallorputoptions

onmovementsoftheCDSindicesthesecanbeusedtocreatenonlinearpayoffprofiles,with

relativelylowcashoutlay,thatareoftendesirableinthecontextoftailriskhedging.

Hedgerscanalsobuyprotectiononspecificslicesoftheindexviathetranchemarket.CDX.IG

tranchesareavailable inslicesofvaryingseniority.Eachtranchehasdifferentsensitivitiesto

idiosyncraticdefaultrisk,economicdownturnrisk,andtailriskwhichallowsforfinetuningto

obtain thedesiredexposure.Todetermine themostappropriateslicegivendesiredpayout,

risk profile, and market conditions, we urge asset owners to discuss the topic with their

trusted advisors.HedgingwithCDX is lowcost, and ismore liquid thanpurchasingCDSon

individual names. Historically, over the long term, CDX hedges had underperformed other

credithedges,andmightbebettersuitedforshorterterm(ormorefrugal)hedgingpurposes.

Bespokesolutionscanalsobecreatedtoimmunizeaclientportfoliosexacttailriskprofile.

For corporatepensionplan sponsors looking toadd creditaspartofan LDI (liabilitydriven

investment)strategy,sellingprotectiononindividualcreditsorindicesmayproveanefficient

meanstoachievethisresult.

Inflation Floor Agreements

Tohedgeagainsttheproblemofincreasedunderfundednessinadeflationaryenvironment,an

asset owner can purchase options that are structured to compensate the owner precisely

whenthisbecomesaconcern. Inflationflooragreementsarestructuredtopayatmaturity if

the cumulative inflation over the lifeof the contract is less than the strike. Inflation floors

performoptimallyindeflationaryscenarioslastingmultipleyearsorinselectyearsthatexhibit

severedeflation. Inflation floorsmustbe rolledperiodicallyandhence requireoperational

diligence tomaintainprotectionand are among themore involved strategies available to

achievetailriskhedging.Cumulativeinflationfloorsarebestusedasportfoliolevelhedges.

Inflation Hedge: Energy Indices

Financialassetssuchasequitiesandbondsfacetheriskoflossfromanunexpectedincreasein

the rate of inflation, which affects the rate at which cashflows are discounted. Hedging

unexpected inflation can be performed in numerous ways, but because a significant

component of these unexpected changes has historically been driven by food and energyprices,a swapona targetedcommodity indexmayproveanefficientand liquidmethodof

achievingthishedge.WerecommendalongonlyinvestmentintheDBOptimumYieldEnergy

Indexasahedgeagainstunexpectedinflation.


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Managed Futures Indices

Asdiscussed, an investment inmanaged commodity futures can serve tohedgeequity risk

throughdiversification.AnexampleofsuchaninvestmentvehicleisDeutscheBanksMATRIX

index,whichprovides thisexposureby referencing abasketof commodity trading advisors

(managers).Managedfutureshaveexhibitedexceptionalperformanceoverotheralternativestrategies during periods of severe market stress, and demonstrate a real diversification

benefitduringtheseperiods. InitialcashoutlayforDBMATRIX is low iftradedviaswap,and

thisstrategycomeswithlowoperationaloverheadsincethereisnoneedtorollorrebalance.

Sovereign Risk Commodity Hedge

In the eventof a sustained andwidespread sovereign risk spillover in Europe, themarkets

shouldpursue flight to safehavenassets suchasGold, followedbya reduction in capital

expenditureandeconomicgrowth,whichwouldbereflectedinlowereddemandforindustrial

commodities

such

as

Aluminum

and

Crude

Oil.

To

protect

against

such

sovereign

risks,

we

suggestbuyingaworstofoption includingacallonGold,aputonCrudeOil,andaputon

Aluminum.Thisportfoliooverlaystrategyhasavery lowpremium (typically~95bps fora1

yearoptionstruck5%outofthemoney)withmaxlosslimitedtothepremiumpaid.

Sovereign Risk Rates Hedge

Inasovereignriskspilloverevent,alowUSDrateenvironmentwouldlikelyprevail.Toposition

againstthisscenario,managerscanpurchasealowstrikereceiverswaptioninUSDasahedge.

Thisoptiongivesthebuyertheabilitytoenterintoacontractinwhichhereceivesafixedrate

whilepayinga floatingrate(typically3monthLibor). Ifa lowUSDrateenvironmentensues,

thebuyerof theoptionwillprofit asheowns a contract that entitleshim topayments at

abovemarketrates.

Hedging Liabilities with Options

AsdiscussedinWhatarewehedging?onpage3,adeflationaryenvironmentisproblematic

forpensionplansponsors.AplansponsorcanuseswaptionstrategiessuchastheSovereign

RiskRatesHedgeabove toprotect funded status fromadeclining rateenvironment.These

strategiescanbecustomizedtoaninvestorstimehorizonanddesiredcoststructure.


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Longevity Swap

As thepeakof thebabyboomer retirementwaveapproachesand retirees continue to live

longer,marketsaredevelopinghedgingsolutionstohelppensionplansmanagethevolatility

of their liabilities. One targeted approach is via a swap that effectively hedges benefit

payments beyond projected life expectancies. In the swap, sponsors pay a fixed stream ofpayments (determined at the inception of the longevity hedge and representing the best

estimateofprojectedpaymentstopensionersplusamargin)andreceiveanyactualpayments

owedtopensioners.Thisreducesthesensitivityoftheplantochangesinthelifeexpectancy

of its members. This opportunity exists due to the recent growth and maturation of the

longevitymarket, aswell as theemergenceofnewmarketparticipantswho seek longevity

exposure.

Swaps on Indices

Swaps

are

an

effective

way

to

realize

the

performance

of

an

underlying

index,

such

as

DB

ELVIS, DB EMERALD, DB MATRIX, or DBLCI (the DB Liquid Commodity Index) without the

drawbacksofusingbalancesheet.Theswapstructureissimpletounderstandandtoenter.By

paying a negotiated ratetypically a fixed spread over Liborand receiving the realized

performanceoftheindex,equitytailriskprotectionisgainedwithminimalcapitalcommitted.

Drawbacks of using swaps can include compromised liquidity, necessity to negotiate ISDA

agreementswith the service provider, and the necessity to roll forward contracts as they

expire.Othermorecomplexvariations(e.g.,notes)canalsoexist.


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Table 3 (a): Asset Tail Risk Hedging Decision Table ConsiderationsWhatare we

hedging?

Active hedgingor

Diversification?

Whatrisk do we h e d ge ? W ha tdo we hedgewith?

Ins trume nt Ca s hOutla y Liquidity

(Y/N) (Y/N)

Domestic

Equi ty Acti veDownturn/Vol ati li ty EqOption Collar $

Variance swa ps $

IndexEMERALD $

Index(ELVIS) $

Options on VIX $$

InternationalEq ui ty Acti ve

Downturn/Vol ati li ty EqOption Collar $

Variance swa ps $

FXRi s k FXOption $$

FXIndex(MSCI EAFEFXHEDGEindex) $

Tre a s uri e s Acti ve

Inflation /Rate I n cr ea s e P aye rswa p $

Payerswaption $$

Cap $$ D ive rs i fi ca ti on Ge ne ra lPortfolio

Index(DB AgFI ) $

Enhanced Index(PULSE) $$

Corpora te s Acti ve

CreditRi s k CDXIndex $$

CDXindexoptions $

IndexTranches $$$

Rea l As s e ts Acti ve

Rea l Estate Exp os ure Swa pon NCREIF $$

FX/Commodi ti es Opti ons $

Futures $$

Forwards $$

D ive rs i fi ca ti on Ge ne ra lPortfolio

Index(DBLCI) $

Enhanced Index(DB Hermes Enh.Comm.Index $$$

Enhanced Index(DB Matrix ManagedFutures $$$

Enhanced Index(DowJones UBS Booster) $$$

Swapon Indices $

TIPS Index(TIPS) ETF $$$$

Alternative As se ts Acti ve

HedgeFundExp os ure Op ti onon Index(HFRI) $$

Are you

an

INHAM?

Can yo

us e a

QPAM


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Table 3 (b): Asset Tail Risk Hedging Decision Table Risks

Whatare we

hedging?

Activehedgingor

Diversification?

Whatriskdo we hedge? Wha tdo we hedge with?

Ins trume nt Eq FI Commod FX No

DomesticEqui ty Acti ve

Downturn /Vol ati l i ty EqOptionCollar high low low low

Variance swaps high low low low

IndexEMERALD high low low low

Index(ELVIS) high low low low

Options on VIX high low low low

InternationalE qu i ty A cti ve

Downturn /Vol ati l i ty EqOptionCollar high low low low

Variance swaps high low low low

FXRi s k FXOption low low low high

FXIndex(MSCI EAFEFXHEDGEindex) low low low high

Tre as uri es Acti ve

Inflation /Rate I ncre as e Pa yerswap low high low low

Payerswaption low high low low

Cap low high low low

D i ve rs i fi ca ti o n G en era l Portfolio

Index(DB AgFI) low high low low

Enhanced Index(PULSE) low high low low

Corporates Acti ve

CreditRi s k CDXIndex low high low low

CDXindexoptions low high low low

IndexTranches low high low low

Real As s e ts Acti ve

Real Estate Expos ure Swa pon NCREIF low low low low

FX/Commodi ti es Opti ons low low high high

Futures low low high high

Forwards low low high high

D i ve rs i fi ca ti o n G en era l Portfolio

Index(DBLCI) low low high high

Enhanced Index(DB HermesEnh.Comm.Index) low low high high

Enhanced Index(DB Matrix ManagedFutures) low med med med

Enhanced

Index

(Dow

Jones

UBS

Booster) low low high high Swapon Indices low

TIPS Index(TIPS)ETF low high low low

AlternativeAs se ts Acti ve

Hedge FundExpos ure Opti onon Index(HFRI) med med low low

SystemicRi s ks

dependsonindexswapped


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DisclaimerThismaterialwaspreparedby aSalesorTrading functionwithinDeutscheBankAGoroneof its

affiliates(collectivelyDeutscheBank).Thismaterialisnotaresearchreportandwasnotprepared

orreviewedbytheDeutscheBankResearchDepartment,andtheviewsexpressedhereinmaydiffer

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Securitiesand investmentbankingactivities in theUnitedStatesareperformedbyDeutscheBank

Securities Inc.,memberNYSE, FINRA and SIPC, and itsbrokerdealer affiliates. Lending andothercommercial banking activities in theUnited States are performed by Deutsche Bank AG, and its

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2010DeutscheBankAG.


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