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Tail hedging solutions for uncertain timesJ.P. Morgan Alternative Asset Management

September 2011

As a result of this, we have recently witnessed increased demand for protection and a profusion of tail-hedging products, which may present challenges to potential investors looking to build a hedging program. At JPMAAM we believe that investors should carefully understand the risk factors when they try to hedge their portfolios and consider the merits of such tail hedging techniques, taking into account considerations such as cost, timing/possibility of monetization and possible crowding effect in tail hedges.

The emphasis of this paper is to discuss the main consider-ations investors should take into account before engaging in a tail hedging program. We will then spend some time focusing on the different tail hedge alternatives available to investors, with their respective pros and cons. We will conclude with JPMAAMs new hedging approach as well as potential institu-tional implications.

A number of recent market events have highlighted the costly impact that improbable or highly unlikely events can have on investors portfolios. The credit crisis in the United States in 2008, the failure of financial counterparties such as Lehman Brothers in the same year, as well as the debt crisis in Europe and the associated political risk more recently have prompted investors to seek ways to protect their portfolios against negative tail events, particularly those that occur on the far left of the return distribution.

Tail hedging solutions for uncertain times

2 | Tail hedging solutions for uncertain times

Rationale for tail hedging and considerationsWe believe it is important for investors to understand the different risk factors embedded in their portfolio and the sensitivity of their portfolio to different risks, such as equity, credit, rates, etc. The traditional approach of purchasing put options on indices (e.g. S&P 500) to protect against the occurrence of a dramatic event has some important limitations. Today there is an increasing number of investors, spooked by the events of 20082009, who have flocked to options as a way to hedge the tail. This has created high demand for puts, resulting in a steady increase in price. As of September 2011, for example, a 15% out-of-the-money put option on the S&P 500 index expiring one year from today would cost a little over 6%, a premium implying a break-even rate of over 21%, which is very expensive by historical standards and could be far beyond what many rational investors would be ready to pay. At JPMAAM, instead of buying a series of out of the money put options on indices, we more appropriately analyse and disaggregate our portfolios on a risk factor basis and we try to hedge out these specific risks.

It is important for investors to understand the different charac-teristics of each of the different hedging techniques available to them: return profiles, attachment points, convexity and negative carry. Attachment points are the level at which protection starts kicking in. For example, options have different strike prices implying different levels of protection. The convexity of a hedge is also a crucial concept for investors to grasp. Protection can either be linear or convex. For example, in a linear protection scenario, if the market is up +10% you could reasonably expect your hedge to lose -10% and if the market is down -10% you can reasonably expect your hedge to be positive approximately +10%. In a convex tail hedging strategy you can expect your hedge to be increasingly effective as the market sells off. For example a sell-off of -10% could generate a return of +60% and

a sell-off of -15% could generate a return of +150%. Negative carry is another important consideration for investors. Negative carry is the cost associated with hedging techniques. For exam-ple, option based strategies have a negative carry which repre-sents the time-decay of the option.

Basis risk is another factor investors should consider before engaging in a hedging program. Basis risk is the risk of a hedge not working, i.e. it is the risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position. For example an investor may realize that it is less costly to hedge a long position in IBM by buying a put option on the entire S&P 500 (as opposed to sourcing the spe-cific IBM stock to borrow and short it). This strategy, although less costly, presents serious flaws as there is no guarantee for the IBM stock to move in tandem with the S&P 500. So chang-ing the basis of the underlying hedge may result in a hedge that is not as efficient as initially anticipated.

The alpha component of a hedging strategy is another important factor to consider. Some hedging strategies - such as buying and selling options opportunistically and monetizing these options, or some idiosyncratic short credit strategies can offer alpha and have the potential to outperform nave index replication.

The capital efficiency of a hedging technique is another key consideration for investors. Some hedging strategies, such as short selling are capital intensive meaning investors have to deploy USD 100 to get USD 100 of notional exposure. Option related strategies on the other hand are more capital efficient due to the implicit leverage embedded in option contracts. The more capital efficient a strategy, the less capital needs to be deployed to reach a certain level of notional exposure or pro-tection. This reduces the cash drag on the portfolio, enabling capital to be deployed more effectively towards other, poten-tially higher yielding investments.

A consideration which is often overlooked by investors is the ability to monetize mark-to-market gains. Hedge fund manag-ers specializing in option trading have the ability to monetize mark to market gains through a number of different tech-niques. Examples of monetization techniques include:

Selling actual put positions that have accrued value

Not rolling into new positions over the course of the month

Covering a portion or all of the positions short delta

Portfolio risk sensitivity Equity, credit, rates, etc.

Sizing approach Insurance budget vs. target level of protection

Return profile Attachment point, convexity, negative carry

Basis risk Risk of hedging failing to provide expected protection

Alpha Potential to outperform native index replication

Capital efficiency Reducing cash drag

Liquidity Ability to monetize mark-to-market gains

Counterparty risk Over-the-counter vs exchange exposure

Transparency Ability to monitor investment

J.P. Morgan Asset Management | 3

The first option, although theoretically feasible, is the most difficult to implement in practice and its viability ultimately hinges on the managers percentage of the open interest and the width of bid/ask spread. The third solution which consists of covering a portion or all of the positions short delta by buying a call option on the wider equity market is really the most tenable short term actionable option as it can be accomplished in the deep and liquid S&P futures market. The manager could also cover the positions short equity exposure by buying call options, but this strategy is not risk free as it could lose money in a scenario in which the market continues to fall, but implied volatility comes in. This is particularly true if the manager is too aggressive in covering their short delta without also selling some of their options positions.

Counterparty risk (over-the-counter vs. exchange exposure) and transparency are important factors to take into account when analyzing the riskiness of hedging programs. Entering into over-the-counter transactions could leave investors exposed to credit risk of their counterparty in case of default and transparency is key to enable the monitoring of the investors investments and net exposure to risk factors.

Tail hedge alternativesThere are a number of tail hedging alternatives available for investors who seek to protect themselves against negative tail events, particularly those occurring at the far left of a return distribution. We have classified these in passive (index), bespoke/customized structures and active hedging strategies.

Passive (index) type of hedging strategies offer potentially lower expenses via internal implementation and has the added benefit of full transparency. On the other hand though, the fire and forget strategy and the limited ability for dynamic management are clear limitations for the strategy. For example, an investor may start a hedging program with a view to protect the portfolio against a given level of equity market sell-off and buy a put option which is 15% out of the money. Lets assume that markets rally by 15% subsequently to the purchase of the hedge. The investor following a passive hedging strategy now holds a put option which is 30% out of the money instead of the initial 15% out of the money, which may offer a level of protection less than the one offered by an active hedging strategy which would continuously roll the hedge. In addition to this, a generic hedging strategy has the added drawback of high basis risk, due to the fact that in most instances the individual risk factors in the portfolio or securities are hedged with broad indices or sector hedges as opposed to individual hedges. The other pitfall of the strategy

is the lack of alpha potential insofar as there is a limited possibility for monetization. An example of monetiz

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