Insuring Against Hidden Financial Catastrophe Risk

Josh Davis and Vineer Bhansali

Returns from most alternative investment strategies can conceptually be thought of as arising from the systematic sale of embedded insurance that can result in disastrous losses during market shocks. In order to retain a meaningful portion of the risk premium earned from this insurance sale, our approach in this chapter will be to extend the concept of re-insurance via efficient tail hedging of such portfolios.

The “endowment model” of investing makes an explicit trade-off between the sale of liquidity and the compensation earned for it. In option terminology, the compensation for locking up capital in illiquid investments is due to the sale of an implicit liquidity option. As long as the sellers of such an option can demand and receive adequate compensation for giving up liquidity, while making sure in the interim that they do not demand it from elsewhere in periods of stress, in principle they should be able to increase longterm portfolio returns. However, is this return enhancement really worth it? Put differently, can investors successfully manage against the occasional sharp losses emerging from hidden risks that are often associated with earning liquidity premia? Since major