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Rolling Tail Hedges: The Dynamic Tradeoff between Cost and Potency

December 21, 2012

Many tail risk clients have expressed a desire to move toward more frequent rebalancing of hedges. One popular frequency is quarterly.
-Vineer Bhansali, managing director and portfolio manager, PIMCO

 

  • In our hypothetical illustration, rebalancing tail risk hedges more frequently than once a year offers some benefit under all volatility curves (ignoring transaction costs) – but the benefits are greatest when the volatility curve is flat or steep.
  • Some of the benefits of rebalancing can quickly disappear if the transactions costs are large.
  • Two key points for investors to consider: Hedging has to be a systematic, repeated, asset allocation decision to obtain best long-term benefits, and the hedge program has to be active and consider pricing levels so efficient rebalancing can be implemented.

When we implement tail hedges, we have traditionally used one year as the hedge horizon. To calculate the premium for these hedges, we start by pricing the explicit one-year hedge and then explore ways of reducing the premium by using indirect hedges. Some of these indirect hedges might consist of cheaper “option-like” positions from other markets that take advantage of potential tail correlations. In addition, we actively manage the hedges in an effort to reduce the realized cost of hedging over this investment horizon.

 

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