Tail Risk Hedging: Investing in Hedges
In fractals terms, the entire system represents the internal complexity on a larger scale. Thinking in this way helps us to realize that we do not have to hedge each and every position in the portfolio to protect ourselves, but rather, to hedge the entire portfolio and add to it some tactical hedges at the micro -level. Consequently, studying and understanding the macroeconomic environment and identifying market cycle phases to hedge against extreme risks can help us avoid huge losses. On the other hand, microanalysis remains vital for generating and protecting short and medium term performance from risk. Bhansali (2007) describes this analytical strategy as follows:
"This correlation allows risks to be broadly hedged at the portfolio level, rather than at the security level, which would be cost prohibitive. Think about it this way: When you purchase homeowners' insurance, you don't insure each item of jewelry and clothing and every appliance individually. You insure the entire house and all its contents. Trying to precisely hedge specific risks would be too complicated and too expensive".
In order to evaluate the impending macro risks, we start by identifying the current environment and by establishing forward-looking scenarios. The assessment of risk is to be done the same way we value assets. By doing so, hedges are assessed as an investment. We are not throwing capital out the window; rather, we are investing for when an extreme unknown event occurs. Macro tail risk investment, depending on the size of the position, can offset some or all the losses of the other investment positions in the portfolio.
Adopting these hedges is like having a contrarian macro position with a specific objective, while other strategies and hedges at the micro level are totally independent. The rationale behind the concept of a tail hedge is that probability values do not matter because major events can happen regardless of their probabilities. Rather than relying on the probabilities, we have to prepare for their occurrence by adjusting the hedging proportion in the portfolio. We have to recognize the limitations of our quantitative and qualitative tools and avoid being overconfident. A well-experienced manager is humble enough to know that combining his qualitative views with quantitative results obtained from mathematical tools of risk-factor analysis, expected volatilities and correlations is the best way of thinking. By acknowledging the limits of the above mentioned sensitivity calculation, a manager intuitively fine tunes his set of tools.