Nothing brings out the tail risk hedging discussions like a good crisis.
And they've been particularly heated this time around.
But in practice, tail risk hedging strategies are incredibly nuanced. Hedgers will consider pro-active monetization strategies (i.e. conversion of our hedge into cash), trade conversion (e.g. converting puts into put spreads), basis risk trades (e.g. buying calls on U.S. Treasuries instead of puts on equities), and exchanging non-linear for linear hedges (e.g. puts for short equity futures).
These wrinkles makes the research of tail risk hedging strategies incredibly complex, as there are so many degrees of freedom.
This week, we aim to tackle just one critique against tail risk hedging strategies: namely that they are highly subjective to path dependency risk.
This argument most frequently emerges because investors assume that protection is held to expiration. In practice, however, this need not be the case.
This week, we demonstrate that when freed from this constraint, the value of buying deep tail risk hedges is not necessarily the terminal payoff, but their convex sensitivity the the market's repricing of risk. Rather than waiting for risk assessed, tail hedgers may be able to profit from risk perceived (PDF).
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→ BAD TRENDS: "The frequency of trend breaks has increased in recent years, which can help explain the lower performance of monthly trend following in the last decade. We illustrate how to repair trend-following strategies by exploiting the return forecasting properties of the different types of trend breaks: market corrections and rebounds." Breaking Bad Trends