We can give three simple reasons to support the use of volatility products to hedge tail risk in fixed income portfolios. First, equity volatility and bond prices have a strong conceptual link. If you think of a corporate bond as functionally equivalent to a risk-free asset (like a Treasury bond) plus a short put option on the issuer’s assets, then the additional yield you receive above the Treasury rate (a.k.a., credit spread) can be thought of as compensation for the sale of that put option. When equity market volatility jumps drastically (as it does during a tail-risk event), the implicit liability from the short put position increases in probability. In a nutshell, the value of bonds will fall as market volatility (yes, even equity market volatility) rises. Read more
Posts tagged ‘tail risk’
Last week I had the opportunity to attend the Atlanta Federal Reserve‘s Financial Markets Conference, titled Maintaining Financial Stability: Holding a Tiger by the Tail. This year’s topic – as the pun in the title suggests – was the regulation of financial firms to manage tail-risk events. Tail-risk events are those that have a statistically low probability of happening, but a large potential cost if they do. They’re called tail-risk events because in a standard normal distribution curve that has a peak in the middle and sloping tails out to both sides, these are the events that take place out in those tails.
Tail-risk events associated with the financial system negatively affect a country’s financial system, and a stable, developed financial system is a key condition for economic growth. Banks and other financial intermediaries exist to move money from households and businesses that have extra (savers) to those who need more (borrowers). An efficient financial system reduces transaction costs and information costs (such as moral hazard and adverse selection), making it cheaper for firms and households to access credit. Read more