Guarding investment portfolios against so-called fat tails, or extreme market declines, is best achieved by a mix of defensive strategies.

The huge swoons in the share market over the past few months again ask the question raised so many times in recent years: what should an investor do to weather extreme volatility? The most practical solutions include choices at opposing extremes – holding cash and buying options-based hedges – with lots of alternatives in between. Which is best?


The costs of cash

PIMCO has done much research over the last eight years of managing so-called tail risk for our clients. Tail risk refers to the visual representation of market outcomes on a bell curve. Most outcomes occur along the middle of the curve, while extreme events are seen at either tail. We’ve come to the conclusion that flexibility and the use of all tools are paramount. Cash, it seems, is not always king.

The main difference between cash as a hedge against systemic risk and, say, put options, is that a dollar of cash remains a dollar of cash regardless of the market, but option values change as either the underlying asset moves down or as the perception of risk changes. As observed during the 2007–2009 credit crisis, the share market ‘flash’ crash of 2010 and again over the past month, the value of not just equity put options, but also options in other risk assets, exploded up as the markets felt more insecure.

This explosive liquidity can be a potential benefit as it can far exceed the value of old-fashioned cash in crisis periods (see Figure 1). This happens in two ways. Firstly, portfolio holdings often show increased correlation (a tendency of holdings to move in lock step) when markets move downward, while tracking equity markets less closely on the upside. So, having cash might not match this downside convexity properly. To match it, one needs convex instruments for which options are one of the simplest tools. Secondly, and beyond this defensive aspect, the availability of excess cash can be used to enter the markets at an attractive level.

Put another way, if you believe that risk premiums increase when the equity markets are doing badly, then each extra dollar is worth a lot more in bad times. The more of these dollars you have, the less likely that the cost of the hedge is a cost over the long run, and the more likely it is to be a benefit. To be sure, this benefit comes at a cost. Options are decaying assets – if time passes and nothing happens, the options lose their value while cash does not. If uncertainty falls, the mark-to-market value of options also falls. The magnitude of time decay also changes depending on what initial price was paid and the distance to the options’ exercise price.

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