Talking Tail-Risk Protection

The extreme equity-market volatility that has whetted investors’ appetite for hedges against deep market drops has also made direct hedging very expensive. But alternatives are available.

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This blog is part of a new series on Institutional Investor entitled Global Market Thought Leaders, a platform that provides analysis, commentary, and insight into the global markets and economy from the researchers and risk takers at premier financial institutions. Our first contributor in this new section of Institutionalinvestor.com is AllianceBernstein, who will be providing analysis and insight into equities.

Property insurance is good for homeowners. No one wants to see their home—perhaps their single most valuable asset—go up in smoke or be flooded. But if the annual premium for an all-encompassing insurance policy were excessively high, homeowners might rightly decide to buy less protection—perhaps a policy with a higher deductible or more limited coverage.

Tail risk in the financial markets is no different. While investors have been eager to protect their portfolios against an extreme market drop for more than a year, the purchase price of the simplest hedge—a put option—has been unusually expensive.

For example, consider the cost of insulating a US equity portfolio against a drop in the S&P 500 of 5% or more. For most of the past 12 months, a one-year put option would have cost at least 2.6% of the value of the portfolio covered (Display). That’s well over the 2% median price of such a put since 1996, though well below the 5% price it reached in late August and the 10.5% price it hit in November 2008.

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Just as property insurance rates skyrocket when there is an unusually high number of claims for hurricane damage, insurance against a drop in the equity market has been costly because market volatility has been extremely high.

But that doesn’t mean there is nothing investors can do to reduce their equity risk besides pay for a put option. Sometimes, when a direct hedge becomes too expensive, it makes sense to hedge indirectly by selling another, highly correlated, asset.

Over the past year or so, the correlation between the euro/dollar exchange rate and equity prices has been unusually high—and for good reason. Both were moving up and down together in response to the ebb and flow of concerns about the European sovereign-debt crisis.

As a result, selling exposure to the euro has been an effective way to hedge equity-market risk. It has also been cheap, because the transaction costs for selling the euro forward are minimal. Moreover, last November our research suggested that the euro was overpriced and carried too much risk, particularly for US investors.

Of course, an indirect hedge does not provide the unconditional protection you would get from a put option. If the high correlation between the euro/dollar exchange rate and the S&P 500 broke down—perhaps because of a sudden rise in concerns about the US dollar or the US economy—the indirect hedge might not protect you very well.

Indirect hedges are most attractive when they cost a lot less than the direct hedge and when there are strong fundamental reasons to believe they should work.

In recent weeks, the price of S&P 500 puts has been near their one-year high and the sovereign-debt crisis has been threatening the viability of the euro. Thus, we find hedging exposure to the euro a very attractive indirect hedge for US investors.

Of course, sometimes, neither direct nor indirect hedges reduce risk enough. Right now, equity-market risk is so high relative to its short-term return potential that it makes sense to reduce (but not eliminate) equity exposure, our research suggests. Sometimes, the best protection comes from moving some of your valuables, at least temporarily.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AllianceBernstein portfolio management teams.

Seth J. Masters is Chief Investment Officer of Asset Allocation at AllianceBernstein.

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