Tail-Risk Hedging: An Empirical Study

Christoffer Hvass Bendiksby & Mabergs Olof Joakim Eriksson

Student thesis: Master thesis

Abstract

All investors are interested in avoiding losses, as doing so can dramatically increase accumulated returns in their portfolios. Put options can effectively mitigate tail risk in equity portfolios but are often found to be too expensive, imposing a substantial drag on portfolio performance. It is however common in the current literature to focus on passive buy and hold put option strategies, i.e. buying options and holding them until maturity. In our paper we implement a rule-based monetization put option strategy, where we allocate a certain percentage of an equity portfolio’s capital to buy put options and combine this with a strategy where the put options are sold if their market price reaches a pre-determined target. The proceeds are then re-invested into equites and new put options. We compare the results to an unhedged position in the underlying equities, represented by the S&P500 TR index, and a position in a constant volatility strategy. We find little evidence that the put option monetization strategies reduce portfolio drawdowns, and we find that all the monetization strategies have lower total portfolio returns and Sharpe ratios as compared to the index. The results are conflicting with other claims and research from option practitioners and can possibly be explained by our inclusion of real life data and differences in methodology. The tested constant volatility strategy reduces drawdowns more effectively as compared to the put option monetization strategies, and it also earns a higher total return and Sharpe ratio as compared to the index. The constant volatility strategy utilizes a negative relationship between market volatility and market returns, and the persistence of market volatility. Our results suggest that simple rule-based monetization strategies are not able to adequately reduce drawdowns and enhance portfolio returns, and that other actively managed strategies, utilizing additional techniques, could be needed to make put option strategies profitable. Investors and portfolio managers may find it easier to achieve the goals of better risk adjusted returns by the implementation of a constant volatility strategy.

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2021
Number of pages90