IPI s 2012 Fall Forum - San Francisco Hedging Portfolio Risk

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1 IPI s 2012 Fall Forum - San Francisco Hedging Portfolio Risk Vince Gubitosi, President and CIO Mitch Livstone, Senior Portfolio Manager Geode Capital Management

2 Outline Defining Tail Risk Tail Risk Examples Why Hedge Tail Risk? Cost of Hedging Tail Risk Not all Tail Risk Hedges are Priced Equally Types of Tail Risk Hedging Strategies Tail Risk Hedging in Practice Geode Capital Management Confidential Information 1

3 Defining Tail Risk Tail Risk can be defined as 3σ (occurs 0.13% of the time in a normal distribution) S&P500 annualized volatility 18% so one month 3σ move is 15.6% Financial asset returns are not normally distributed so large moves occur more frequently Observed in recent history Analytically shown by Markwat estimates global market crashes are 15 times more likely now vs Tail event also defined as event perceived as unlikely by the market Probabilities can be implied from market prices Example: Greece CDS trading 50bps in Aug 2008 => Greek default is a tail event Greece CDS trading at 80points upfront => Greek default not a tail event Geode Capital Management Confidential Information 2

4 Tail Risk Examples VIX Index WTI ($) Summer 07 Equity Volatility Summer '07 - Equity Volatility VIX Sep-07 WTI Jun-10 Future +40.8% in 13 business days 4.5σ based on a 40% Historical Vol 2.25σ based on a 80% Implied Vol 10 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 May 10 - Oil 5σ based on a 18% Historical Vol 3σ based on a 30% Implied Vol May '10 - Oil -22.9% in 16 business days 65 Mar-10 Apr-10 May-10 Jun-10 S&P Index Level Yield % US Treasury Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec Fall 08 US Equities Fall '08 - US Equities S&P 500 Index 3.2σ based on a 30% Historical Vol 3.2σ based on a 30% Implied Vol Summer 11 US Rates Summer '11 - US Rates 10-year US Swap 4.6σ based on a 80% Historical Vol 3.4σ based on a 100% Implied Vol -40.1% in 44 business days -89bps in 16 business days 1.6 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Data Source: Bloomberg and Geode Capital Management Geode Capital Management Confidential Information 3

5 Why Hedge Tail Risk Why hedge tail risk if it may add negative expected value in your portfolio? Reduce drawdowns - important for meeting constant liabilities Smoother return stream increases Sharpe ratio asset allocation decision Survival and investor psychology Frictional costs of large drawdowns Investors more likely to make irrational decisions after large drawdowns Investors can become too risk averse Investors can swing for the fences when facing sure loss Geode Capital Management Confidential Information 4

6 Event Probabilities Implied by Option Prices We can infer probability of tail events from market prices of options Example S&P500 put options SPX down 10% in 1m SPX down 20% in 1m SPX down 30% in 1m Min 0.51% 0.01% 0.00% Max 30.47% 18.13% 9.72% Average 6.30% 1.37% 0.37% as of 3-Aug % 0.61% 0.15% %-ile as of 3-Aug % 41.50% 46.90% Probability 35% 30% 25% 20% 15% 10% 5% Implied Probability of Tail Risk Event Implied Probability of Tail Risk event SPX down 10% in 1m SPX down 20% in 1m SPX down 30% in 1m Data Source: Goldman Sachs 0% Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11 Geode Capital Management Confidential Information 5

7 Factors of Tail Risk Hedging Cost Pricing of Tail Risk hedges reflected in traded risk premia across asset classes: Implied / Realized volatility premium (expensiveness of options) Term structure (long dated vs. near dated options) Skew (expensiveness of Out-of-The-Money puts vs. calls) Convexity (expensiveness of Out-of-The-Money options vs. At-The-Money options) Corporate Credit Spreads (reflective of probability of default) Tail risk also reflected in market conditions (bid/offer, liquidity, slippage) Geode Capital Management Confidential Information 6

8 Factors of Tail Risk Hedging Cost VIX Index (LHS) SPX 1m Realized Volatility (LHS) Spread (2m Avg) (RHS) SPX Volatility Premium SPX Volatility Premium Volatility (%) (5) (10) Volatility Spread (%) 0 Feb-05 Feb-06 Feb-07 Feb-08 Feb-09 Feb-10 Feb-11 Feb-12 (15) VIX Future s VIX Term Structure Premium VIX Term Structure Premium VIX Fut 5th Contract (LHS) 10 VIX Fut 1st Contract (LHS) 0 Spread (RHS) Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan (5) (10) (15) (20) (25) (30) (35) VIX curve slope Data Source: Bloomberg and Geode Capital Management Geode Capital Management Confidential Information 7

9 Not All Tail Hedges Are Priced Equally Supply/Demand imbalances cause many tail risks to be overpriced SPX crash protection, VIX upside are among assets that generally have a natural bid from: Dealers who need to reduce their crash risk Systematic tail risk hedging funds Some tail risks in FX and Rates seem cheap Low absolute levels of volatility and low implied/realized premium Flatter term structures mean lower roll down cost or minimal decay Active Tail hedging strategies can take advantage of this Buy protection only if the cost is reasonably cheap Volatility arbitrage funds can sell expensive protection and hedge with cheap tail risk insurance Geode Capital Management Confidential Information 8

10 Different Types of Tail Risk Strategies Tail risk hedging strategies vary by philosophy, approach, and expertise Systematic vs. Active Proponents of systematic strategies (often dealers) advocate that one cannot time the market Proponents of active strategies advocate that market conditions should be taken into account when trading (consider varying leverage, asset selection, structures, tenors, etc.) Listed vs. OTC For listed, counterparty risk is with the exchange and structures are limited to shares, futures and vanilla options OTC subject to more counterparty risk, but much richer investment universe New Dodd-Frank regulation will move more derivatives to exchanges Single asset focused vs. multi-asset class (depth vs. breadth?) Single asset class allows deep focus, but greatly constrains investment universe Multi-asset class provides much larger flexibility in investment universe Geode Capital Management Confidential Information 9

11 Preferred Tail Risk Hedging Approach Active / OTC / Multi-Asset Buy tail protection that is the cheapest available across global markets and across asset classes assumption that correlations will rise in global crash Buy protection only if the cost is reasonable (i.e., it s priced as a true tail risk) Diversify across: Asset classes: Equities, FX, Rates, Credit, Commodities Assets within classes Tenors Strikes or moneyness Structures Puts, put spreads, volatility swaps, variance swaps, options on variance, VIX futures/options, forward volatility agreements (FVA), swaptions Counterparties Vary leverage with cost of tail risk Geode Capital Management Confidential Information 10

12 Lessons Learned Don t wait too long to monetize hedges Allow leverage to vary to keep decay rates more stable Worry about correct marking to market and collateral Counterparty diversification on OTC trades Avoid some counterparties on specific trades e.g., trade that insures against Euro break-up better traded with large US bank than French bank Ladder tenors to have capital available when attractive tail hedges become available Geode Capital Management Confidential Information 11

13 Examples Long Bovespa Put Spread to benefit from upward-sloping forward and moderate implied volatility / skew Long EURHUF Forward Volatility Agreement (FVA) BSVP Index Level (BRL) BVSP Forward 6.8% ann. higher than spot IBOV Index BVSP Futures Curve at Inception Put Spread Long Strike Put Spread Short Strike Dec-12 80%/70% BVSP Put Spread bought for 70bps (14.3x) impact of the forward is a 40% discount FX volatility (%) EURHUF 6m6m FVA (LHS) Hungary 5y CDS (RHS) Sovereign Credit Still Elevated FX Implied Vol DOWN Hungary CDS ($) Apr-12 6-Jun-12 8-Aug Oct Dec-12 5 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 0 Data Source: Bloomberg and Geode Capital Management Geode Capital Management Confidential Information 12

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