Using Equity Options and Volatility to Manage Tail Risk

Arié Aboulafia

This chapter advocates the use of equity options and volatility instruments as the best way to mitigate and manage tail risk in multi-asset institutional portfolios. After briefly considering the limits of traditional diversification and the rationale for focusing on equity, it discusses some of the desirable characteristics of an “ideal” tail hedge. We then look in more detail at the four main equity option and volatility-based tail hedges, comparing their respective merits and drawbacks. The chapter is based on the author’s practical experience in designing and implementing tail hedging protocols that draw on techniques developed in volatility arbitrage. The discussion of optimal portfolio construction and management focuses on systematic relative value analysis as the cornerstone of successful tail risk hedging. We conclude with a brief discussion of the cost of convexity.

THE LIMITS OF DIVERSIFICATION: BROAD EQUITY RISK

Traditional asset allocation, built on the principles of modern portfolio theory, relies heavily on diversification benefits both across and within asset classes. However, it has repeatedly proven vulnerable to the fact that correlations are not constant and