Tail Risk Management

Abstract

In the current deleveraging episode, the severity and simultaneous realization of low-probability events across a number of strategies has brought portfolio tail-risk hedging to the center of investors' attention. In this article, the author discusses the basic principles and implementation considerations behind portfolio tail-risk management, emphasizing the importance of viewing tail risk as the consequence of a systemic shock during which normally uncorrelated markets become correlated due to a reduction in liquidity. This approach suggests that tail risk should be measured by performing macro scenario analysis and that hedges should be picked based on their cost and joint performance in periods of stress relative to the portfolio being hedged. Since liquidity reduction is a typical consequence of systemic shocks, the author also discusses specific operational issues that come to the fore in such events.

TOPICS: Tail risks, portfolio construction, analysis of individual factors/risk premia