The Eurozone debt crisis has been the focus of the investment world for over a year. We look at this debt crisis and see how investors can hedge against "very unlikely" Black Swan events relating to sovereign debt. Tail risk hedging is a concept that is quickly catching on, and sell-side firms are busy packaging these strategies for their clients. In this article, we first examine the concept underlying tail risk hedging and its growing market. We then link this concept with the debt crisis in the Eurozone. Lastly, we suggest a few simple tail hedges for 2011.
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 returns are concentrated in the bulge near centre of the distribution. The tails at the extreme ends represent events that are highly improbable. Tail risk defines the risk posed by such events. These events are usually triggered 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.
In the recent period between 1980 and 2010, there have been several "left-tail" events as shown in the below table, far more than anticipated by the left tail of the distribution. These events have eroded the value of the portfolio long term investors.
Figure 1: Examples of some tail events in the past [1]
Why are we talking about this today?
In the aftermath of the 2008 crisis, financial markets world over are still in the process of recovery, albeit at different stages. With no clear sense of direction, markets like the US and Europe are still fighting fears like the double dip, stimulus pull back and default on sovereign debt. For investors therefore, the desire to hedge left tail events is a rational response to the not so unlikely extreme events as exhibited by the historic data.
The chart below demonstrates this risk by showing the peak-to-trough drawdown of the US equity market since 1926. The recent crisis led to a 50% drawdown. [2]
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.
Figure 2: Peak-to-trough drawdowns 1926-2010, S&P 500 [3]
Growing market for tail hedges
An article on Bloomberg referred to fear as being the 'hottest new product' on the street [4] . 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 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. [5]
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. [6] 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. [7]
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. [8] The growing popularity has caused prices of out-of-the-money (OTM) puts and sovereign Credit default swaps rise, making tail risk hedging an expensive game - no longer a very "cheap protection."
Eurozone debt-crisis and fear of tail events
Recently, Portugal completed a successful bond auction. While counter intuitive in the light of recent events in PIIGS (Greece and Ireland in particular), this does at some level confirm beliefs regarding the unlikely hood of Eurozone nations defaulting on debt. Even though yields in the PIIGS have peaked, the spreads are wide, and Germany openly unhappy with the euro situation, the possibility of a default and subsequent disintegration of the Eurozone is still a distant thought. However, for an investor in European debt, a strategy could be to hedge against this highly improbable tail end event.
Sivan Mahadevan, global head of equity and credit derivatives strategy at Morgan Stanley, says that trading in those options that are used to gamble on price swings in benchmark European credit-default swap (CDS) indices rose fivefold from January to June 2010. An ever rising portion of these trades are also speculative bets on very low probability events.
Country
5-yr Mid bps (1st oct)
5-yr Mid bps (31st dec)
Change (%)
Belgium
128.9
219.8
70.4
Spain
229.1
347.7
51.8
Germany
39.0
59.1
51.7
Netherlands
45.7
62.8
37.4
France
79.3
107.3
35.2
Table 1: Worst quarterly performances - percentage change [9]
Securities houses have sold out-of-the-money protection against debt default by countries outside the PIIGS cluster - including France and the United Kingdpom. CDS spreads on French debt (on Jan 7, 2011) were at 110bps - that's greater than spreads of Thailand (100bps) and Brazil (107bps) and same as that of Mexico! Credit rating agency Fitch says that this is because investors are using CDS for hedging against fat tail events related to French credit that may arise due to linkages with the periphery Eurozone countries. [10] Europe is not the only region which has been facing the debt issue. Dubai had a case of tail event relating to its debt situation is late 2009. PIMCO was advising selling protection on Japanese sovereign debt in October 2010. [11]
Figure 3: Volatility premium in puts over calls (last 3 years) [12]
Figure 4: Effect of Eurozone crisis on volatility premium in puts over calls [13]
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 [14] . 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. [15] 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. [16]
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%
Finally, 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.
About the authors
Megha Goyal: A first year student at IIM Bangalore, she holds a dual degree in Chemical Engineering from IIT Delhi. Megha will be interning with Morgan Stanley in the fixed income division. Prior to this, she has worked in synthetic equities at Deutsche Bank.
Puneet Gupta: Puneet Gupta is a second year student at IIM Bangalore, and is a member of the Director's Merit List there. He completed his electronics engineering from BITS-Pilani, Goa Campus and has interned with Citibank, Singapore and Goldman Sachs, Hong Kong.
Umang Mittal: Umang Mittal, a Computer Science Engineer from IIT Delhi, is currently a second year PGP student at IIM Bangalore. He is a member of Director's Merit List at IIMB. He interned in Goldman Sachs, London and would be joining GS as an analyst in May, 2011.
