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The Journal of Credit Risk (115126) Volume 5/Number 2, Summer 2009

Tail-risk management: an investors

perspective
Vineer Bhansali
PIMCO, 840 Newport Center Drive, Suite 300, Newport Beach, CA 92660,
USA; email: bhansali@pimco.com

Investors take risks to deliver excess returns over their benchmarks. The most
recent crisis in the financial markets has re-emphasized the need for practical
principles to evaluate what risks are acceptable for long-term performance
and which ones are better hedged out. This paper summarizes ten operational
rules for tail-risk management of investment portfolios that investors ought to
consider when constructing portfolios, especially those that have potential for
impact from adverse credit events.

1 INTRODUCTION
No risk management term has entered the vernacular of investors as rapidly as tail-
risk management has in the last three years. Market participants have not only had
to deal with a substantial loss to their wealth, but also to their confidence, and most
of all to many core principles of investing that they have held dear almost forever.
What has the crisis taught us about investment risk management?
The most important lesson that we have learnt is that, although the details of this
crisis are different, in many ways the current episode has striking similarities to past
crisis events. Among these similarities is the central role played by deleveraging,
illiquidity and flight to quality, with a spike in the degree of comovement of assets
and the inability of investors to anticipate the degree of damage to portfolios.
This crisis has also taught us that well-positioned portfolios are not only those
that outperform others in periods of normalcy, but those that can weather storms.
Whether one can anticipate the exact nature of these rare events is doubtful; but
just as homes in areas that are prone to natural disasters are designed to withstand
significant stresses, portfolios in increasingly accident-prone markets are designed
with structural risk control to survive severe market catastrophes. While the nature
of these catastrophes changes with time, there are usually sufficient opportunities to
fortify portfolios against the most perverse crises at a reasonable and relatively small

I would like to thank PIMCO colleagues and clients who saw the need for tail-risk hedging when
others did not, and encouraged the development and implementation of our thoughts ahead of the
subprime crisis of 2007.

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116 V. Bhansali

cost to portfolio performance. This offensive risk management is being increasingly

used by portfolio managers to construct portfolios that are robust to what we expect
to be volatile and highly unpredictable financial conditions.
In the following sections I have outlined some of the principles of risk manage-
ment that I think should be in the back of every investors mind when constructing
portfolios.

2 TAIL-RISK MANAGEMENT: NECESSITY NOT LUXURY

Any home or automobile owner will attest that the benefit of having appropriate
amounts of disaster insurance is financial survival. When applied to investors, there
is a secondary benefit: that the survivors are better able to take advantage of reduced
liquidity and attractive prospective returns. Thus tail insurance is an offensive strat-
egy for the long term, even though it may appear to be a cost in the short term.
When a homeowner purchases insurance against a catastrophic event that might
destroy the roof over their head, they do not regret having paid the premium at
the end of the year. If we think of investment portfolios in a similar way, it seems
almost incomprehensible that investors would decide to run portfolios without tail
insurance.
The single most important reason investors give for not including tail-risk man-
agement strategies in their portfolios is that it costs returns. While there is no arguing
with the fact that spending on tail risk requires sacrificing returns (either via mov-
ing off the optimal frontier of risky assets, or spending explicitly on insurance),
the reality is that over long horizons, the same insurance results in a multiperiod
enhancement of the return characteristics of the portfolio.

3 PORTFOLIO TAIL RISK EQUALS SYSTEMIC RISK EXPOSURE

Systemic risk brings under pressure the ability of funds to carry levered holdings
since leverage is a permanent risk in our economy, the likelihood of tail-risk events
increases as the risk of deleveraging increases. In such episodes everyone desires
liquidity and no one is willing to provide it. Financing and liquidity are macro risks,
and hence their proper valuation requires macro models, and proper hedges require
macro tools and market instruments.
This observation has far-reaching consequences. The main consequence is that
tail risk becomes a macro risk, and to forecast and control against it one needs to
step outside the world of historical estimates and calibration and forecast structural
changes, and imagine improbable, high-severity scenarios. The immense benefit of
thinking of tail risk in terms of a macro risk is the simplification of hedges. Macro
markets are the deepest markets, and typically there is some sort of insurance that
remains attractively priced for long enough because of the sheer mass of capital
reallocation needed to align all of them. When systemic crises happen, correlations

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Tail-risk management: an investors perspective 117

also rise in their absolute value. This provides a free lunch, in that a completely
disconnected macro market in normal times becomes a good hedge against the tails
in distressed times. It is more efficient to sacrifice basis risk and close matching of
hedges in order to obtain efficiency of hedges. For example, due to the beta of credit
to other markets, credit market tail-risk events are frequently hedged better with
equity options and currency options than with customized credit hedge instruments.
Indeed, this blurs the distinction between an active position and a hedge, but when
the dust settles the classification of a position into ex post categories is less important
than the economic benefits it confers.

4 VARIABLE COSTS, CHANGING OPPORTUNITIES

Credit market hedges were extremely cheap in 2007, because of the incessant sell-
ing of structured products and the demand driven by excess liquidity. These same
hedges are not as attractively priced today (though there are others that are). Thus
hedging credit with credit market instruments might no longer be an attractive solu-
tion. The estimation of option prices and sensitivities in general is based on the
academic foundations of continuous trading and risk-neutral investors. As I have
written previously (Bhansali (2007b)), these ideal conditions are rarely met in tur-
bulent markets. Hence using what are now traditional models of option pricing are
flawed by construction when applied to tail hedges. A viable alternative approach
is to run scenarios that investors are averse to and evaluate the expected value of
portfolios under those scenarios with and without insurance assets. The difference
in these two portfolio values is the proper price for the insurance from the investors
perspective and might be superior to the market price of the insurance. We all
know that catastrophe insurance can trade too cheaply in the natural insurance mar-
kets; it is possible for this to also happen in the world of finance, especially in a
world of innovative financial engineering that ports risks from one type of market
to another.
Why is it that cheap tail hedges can be found in almost all market environments?
There are many possible reasons. For example, speculative demand for particular
types and classes of assets may drive the price of these assets very high. In periods
of low returns, as observed until the middle of 2007, yield hoggers increased
options sales as a source of carry. The belief of mean-reversion participants is that
out-of-the-money options will never be exercised. This is generally true, except that
as the leverage in the market place increases due to everyone simultaneously doing
levered option sales, the notional size has to increase to generate the same carry.
At some point this type of system becomes unstable to small noise and creates a
domino effect of hedgers all trying to cover their deltas at the same time (the other
choice is to risk certain ruin).

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118 V. Bhansali

A cost calculation example will make this obvious.

Prior to the credit crisis, in June 2007, a 7100 tranche on the IG8 CDX
10 year index cost 15.63 basis points per year (bps/year). The running cost
is the coupon/year of spread duration, which equaled 2bps. Since the tranche
rolls down to a shorter maturity, per year the roll down is 2.67bps for a total of
4.67bps of cost. To short 1 billion notional, the total lifetime cost was about
US$12 MM (cost times PV01 of 7.45).

The same tranche in February 2008 was trading at 91bps/year. Then, running
cost (coupon)/year of spread duration equaled 10.1bps, roll-down equaled
2.2bps, for a total of 12.3bps/year. The new total lifetime cost is about
US$67 MM.

The delta of the tranche before the crisis was approximately 0.53, which
when multiplied by the spread duration of the 10 year index of 7.45 gives an
approximate sensitivity of 3.95% per 100bps of index widening. In February
2008, the delta rose to 0.77 (since the index widened and was closer to at-the-
money), increasing risk to 5.66%.
It can immediately be seen why super-senior levered notes are in severe dis-
tress today (and why the reverse of selling insurance was so rewarding). First, the
mark-to-market loss is huge (five times) since it equals the net present value of the
premium change. Second, the mark-to-market benefits from convexity (the delta
increased). And third, the collateral that has to be posted to make up for the mark-to-
market fluctuations is much more expensive. The fact that all these things happened
simultaneously is typical of systemic tail events.

5 THERE ARE MANY WAYS TO IMPLEMENT

The simplest way is to buy insurance securities. For instance, credit market crises
almost always occur with deleveraging and a grab for liquidity that usually results
in treasuries rallying in price terms, especially those at the shortest maturities. So
short-term cash and treasuries are a natural asset-based hedge for tail risk. But
these securities can become overpriced for other technical reasons. The second
option is to buy contingent claims, or option-like securities. A few months ago,
out-of-the-money tranches on the CDX and iTraxx indexes were literally being
given away due to the demand for default remote structured transactions such as
constant proportion debt obligations, levered super-seniors, etc. These option-like
payouts were priced below their expected value under a significant systemic risk
outcome. The third alternative is to invest in strategies that are negatively correlated
with tail risks. Essentially this approach balances risks in portfolios with risk-factor
exposures that are likely to negate some of the adverse returns embedded inside the
portfolio. Among the traditional, established strategies, Figure 1 on the facing page

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Tail-risk management: an investors perspective 119

FIGURE 1 Correlation of typical hedge fund strategies versus the VIX index for different
periods.

10 years ended January 08 Tech bust (AprilNovember 00)

July 07January 08 LTCM (AugustNovember 98)

1.0
Positive correlation
(lower volatility, higher return)

0.5

0.5

1.0
Composite
hedge fund
Convertible
arbitrage
Dedicated
short bias
Emerging
markets
Equity market
neutral
Event
driven

Distressed

Risk
arbitrage
Fixed-income
arbitrage
Global
macro
Long/short
equity
Managed
futures
Multi-
strategy
Source: PIMCO.

demonstrates that only the systematic, trend-following, managed futures strategy

provides positive correlation with tail-risk indicators such as the VIX index, while
also being largely uncorrelated with the stock market. Copious amounts of research
have been done to demonstrate that trend-following strategies behave like a long
position in lookback straddles and hence are naturally long tail risk (Fung and Hsieh
(2001)). The fourth approach is to move the portfolio off the optimal frontier, ie,
accept less return for the same amount of risk. This approach explicitly recognizes
that the simplest mean-variance optimal frontier falsely assumes that risk can be
measured by volatility alone and that the investor has perfect forecasting ability.
One example of this approach is to reduce the exposure to spread products, such as
corporate bonds or low-quality mortgages. Such spread products have higher yield
because of embedded default and illiquidity options and are hence more vulnerable
to systemic shocks. Unfortunately, such dynamic hedging has limitations.

6 MORE THAN JUST DYNAMIC REPLICATION

The problem with these types of zero-cost tail solutions is that they assume that
liquidity will be present in crises, and usually liquidity evaporates during systemic

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shocks. When everyone else is trying to put on the same hedges, there is no guarantee
that an investor will be able to do so before others. In the approach we are describ-
ing the portfolio is subjected to reasonable but rare super-shocks and insurance is
purchased using one of the four techniques previously listed. So there is an explicit
price to be paid for the hedge. The role of the portfolio manager is to reduce the
cost of these hedges over the hedge horizon. Especially when the horizon is long
enough, hedges can usually be bought very cheaply. For instance, long-dated options
on foreign exchange such as the US dollaryen exchange rate recently had negligible
cost over a one-year horizon due to the roll-up of forward rates from the interest
rate differential between US dollar rates and yen rates (see Bhansali (2007c)). In
periods of stress one common outcome is deleveraging and flight to low-yielding
currencies such as the yen. This directionality of the foreign exchange movement
and the associated increase in volatility makes the real-world expected value of the
hedging package much higher than the theoretical, risk-neutral value. So it is the
possibility of asymmetric payouts in particular states of the world that makes the
hedges worth more to the investor than their stand-alone theoretical value.

7 TRADITIONAL VALUATION MODELS ARE LESS RELEVANT

To ascertain the value of a particular tail hedge, it is critical that the scenario analysis
be performed with many variations of the inputs for the parameters. The inputs are
more important than the level of refinement of the models. In the simple language of
BlackScholes options, this boils down to running the performance of option posi-
tions under various maturity, rate, volatility and spot rate environments, using the
option model simply as a crude non-linear transformation machine between inputs
and outputs. Special attention has to be paid to consistently taking the volatilities
and correlations to extreme values, because the underlying assumption of joint log-
normality undervalues the tails of the distribution (see Bhansali and Wise (2001)). It
is also possible to approach the problem by specifying other distributions with natu-
rally fat tails, such as the Lvy distribution, and todays computational power makes
it easy to substitute for theoretical, closed form solvable models with empirical
distributions that can be evaluated numerically, especially in the tails.
The extension of BlackScholes to credit is the Gaussian copula model. While
it is too simple in its details it still has the ability to give good intuition about the
performance of tranches in periods of stress. In Table 1 on the facing page, I have
displayed the performance of a 7100 tranche on the IG8 index for instantaneous
shocks and one-year delayed shocks. The particular data used is not as relevant as
the fact that the scenario analysis illustrates the profile of the hedges with changing
correlation assumptions. The point here is that the tranche returns can be different as
the implied base correlation moves around. In periods of systemic stress, correlations
between credit entities rise as we go from the first column to the second, so there
is additional convexity from the correlation variable. This in turn makes the hedge

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Tail-risk management: an investors perspective 121

TABLE 1 Tranche shock scenario analysis.

(a)

PriceDate March 26, 2008

Index IG8
Tenor 10
Funded 0
attPoint 7.00%
detPoint 100.00%
Coupon (bps) 76.7

(b) Delay for shocks (years): 0

Spread (Attachment correlation %) 63.38 95.08 31.69

boost (bps) (Detachment correlation %) 0.00 0 0

25 1.36 0.39 2.49

10 0.55 0.45 1.68
0 0 1 1.13
10 0.55 1.56 0.57
25 1.39 2.39 0.29
50 2.77 3.76 1.74
100 5.54 6.46 4.66
200 10.84 11.58 10.25

(c) Delay for shocks (years): 1

Spread (Attachment correlation %) 63.38 95.08 31.69

boost (bps) (Detachment correlation %) 0.00 0 0

25 1.99 1.07 3.08

10 1.28 0.34 2.38
0 0.8 0.16 1.91
10 0.32 0.65 1.42
25 0.41 1.38 0.67
50 1.65 2.6 0.61
100 4.1 5.01 3.2
200 8.89 9.64 8.26

This table shows the shock to the 7100 tranche of the IG8 CDX index and the resulting performance in points. In
(b) we shock the spreads of the index (displayed in first column). The second, third and fourth columns show the
performance of the hedge under different base correlation assumptions using a Gaussian copula model. Part (c)
repeats the exercise for a one-year horizon shock, so it incorporates time decay in the hedge.

perform better for increased correlation in periods of stress. The one-year horizon
shock accurately captures the cost or time decay as the tranche (which is nothing
but an option on losses) shortens in maturity.

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FIGURE 2 Allocation of the CDX 5Y index to idiosyncratic, sector-wide and systemic

risk factors.

250

200
Spread (bps)

150 Sector-wide risk

100 Systemic risk

50 Idiosyncratic risk

0
Mar 04 Mar 05 Mar 06 Mar 07 Mar 08 Mar 09

The three lines are the idiosyncratic component, the economy-wide risk and the sectoral risk, as indicated. The
economy-wide risk is at highly elevated levels. This figure is from Bhansali et al (2008).

8 PARTICIPANT ACTIONS BECOME MORE RELEVANT

In recent work (Bhansali et al (2008)) we break down the index spreads for various
indexes using a three-jump approach first used by Longstaff and Rajan. The third
component of the spread, which corresponds to systemic risks, has clearly become
elevated in the recent crisis and may only revert to normal levels with a long lag
and after substantial liquidity is provided to alleviate insolvency fears. Regression
of other markets, such as municipals, asset-backed securities, etc, on the systemic
component of the spread shows significant dependence of prospective returns on
how the systemic risk factor changes. In other words, many asset classes carry large
amounts of systemic illiquidity risk. No wonder that, at the time of writing, municipal
bonds, especially general obligation bonds of natural AAA-rated states, are trading
at even higher yield levels than treasuries, despite the fact that they are tax exempt.
The impact of government action on systemic risks is obvious when we compare the
systemic and idiosyncratic components in Figure 2. Prior to the Bear Stearns event in
spring 2008, the systemic component had already started to rise and reached the same
order of magnitude as the idiosyncratic spread component. When the government
provided unprecedented liquidity this component of spreads started to narrow. With
the mid September failure of Lehman Brothers the authorities had to make a choice,
in which they sacrificed the interests of common equity holders relative to senior
debt holders. We see that the tranche markets immediately responded to this choice
with the idiosyncratic component blowing out. This, as is discussed further below,
coincided with the meltdown of the equity market that saw a decline of almost half
in its capitalization.

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Modeling asset prices can be thought of as a product of payouts, probability

distributions and discounting. A government with unlimited legal and monetary
powers can quickly change any or all of these elements of pricing, altering asset
values and risk in a fundamental way. Thus incorporating the effect of participants
starts to play a critical role in risk management, which has unfortunately been swept
under the rug in traditional pricing models.

9 ASSET-CLASS DIVERSIFICATION IS ALMOST USELESS

The construction of a tail portfolio hedge depends on three interrelated inputs.
First, what is the scenario behavior, or beta, of the portfolio? Second, what is
the deductible or the amount of loss that the investor is willing to self-insure?
Third, what is the cost that the investor is willing to spend on the hedge? The best
combination of hedges is the one that balances return and risk. The hedge performs
by reducing the negative return to the portfolio in the stress scenario, and in addition
controls the risk at the horizon to the dangerous factors in the stress scenario. This
evaluation of tail hedges with a holistic perspective on the portfolio is critical, as
our experience with bond markets over the last two years has demonstrated.
Bond investors like to think of bonds as a separate asset class from equities. Alas,
the performance of fixed-income markets in 2008 showed us that bonds have a lot
of equity risk in them. Until the Lehman Brothers bankruptcy, the equity market
was living in its own world; the default brought home in a hurry the truth that
equity holders are ultimately taking the bulk of the enterprise risk. Since then every
bond class other than treasuries has tracked the gyrations of the equity markets.
Conceptually this makes sense since equity markets are where the collective animal
spirits of investment live, and increasing risk aversion is experienced first hand when
one meets equity markets in free fall. The well-known Merton model that links credit
spreads to equities is indeed based on the relationship between both equities and
bonds issued by a corporation and underlying assets, and so the observation that
a fall in the asset value of a company impacts both corporate stocks and bonds is
hardly surprising. What is shocking is that so many asset classes that have nothing to
do with corporations and their assets have become so correlated with equities. Pure
alpha strategies have shown little alpha and much equity market beta. Over the last
few months, a watchful investor could generally guess the daily direction of bond
levels and yield curve shape, currencies, commodities and credit just by observing
the changes in the equity market. This correlation of assets at the macro level has
brought home the fact that much of the real risk of investments resides in the equity
markets, and when the cuts from deleveraging get as close to the backbone of finance
as they did last year, the equity market becomes the final risk shock absorber. Even
though the stock market itself has remained fairly liquid through the crisis (so far),
falling equity prices are more likely to result in falling liquidity of other asset classes
than rising equity prices are. At the end of the day, in a levered economy in which

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124 V. Bhansali

assets are being supported by a diminishing equity base, each unit of falling equity
prices very drastically magnifies the economy-wide leverage. If we are on a path
of deleveraging that is not at its final resting place, then this denominator effect
(where equity is the denominator and the net assets are the numerator) will require
a further downward adjustment of the numerator, ie, of asset valuation broadly.
To see the impact of this simple approach in more detail, let us go back to asset
pricing done the arbitrage pricing theory way. By definition, the beta of the stock
market to itself is 1. The beta of any other security is the correlation of its returns
times the ratio of the volatility of the asset to the volatility of the stock market. So if
a security such as a treasury bond shows a beta of 0:10, that means that its returns
are negatively correlated to the stock market. On the other hand, high-yield bonds
show an equity beta of almost 1, ie, not only are they positively correlated to the
stock market but they have volatility of the same order of magnitude as the equity
market. One would only want to buy such a security if the compensation for holding
the default risk exceeded the risk from the market volatility of the equity market
by a wide margin. Many hedge funds and other absolute return strategies turned
out to be absolute negative strategies in 2008 for similar reasons: they were short
hidden equity, or what amounts to the same thing, liquidity risk. Higher equity beta
should, in efficient markets, compensate with higher return, or so goes the capital
asset pricing model, but higher beta also means higher drawdown and tail risk.

10 SEVERITY IS MORE IMPORTANT THAN PROBABILITY

The probability question for tail events is typically not answerable by looking at
traded option prices since they are based on assumptions that typically fail for very
rare events. The reason being that the pricing of tail options in particular carries a
significant amount of risk premium compensation to the seller (lottery ticket risk),
which alters the probability distribution. Simulation that is based on past observa-
tions is also not a totally satisfactory approach, since each crisis varies in severity
and magnitude. There are a number of parallel practical approaches to coming up
with probabilities. One approach is to sample from historical events with replace-
ment and magnify the rare-event likelihood by some scale factor (this effectively
reshapes the tails). Simultaneously, changes in a tail-risk indicator such as the VIX
can be measured to indicate the likelihood that we are in a crisis versus a normal
environment.
We have already demonstrated that in events of systemic importance, many asset
classes suffer substantial losses. Since these losses happen due to the sharp removal
of liquidity and leverage, focusing on the probability alone ignores the fact that
the damage happens due to the size of the shock. The lesson is that regardless of
how these probabilities are estimated, investors should look to accumulate cheap
tail hedges that benefit the portfolio. The probability calculation is less important

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than knowing that hedges exist that can make the difference between survival and
almost certain ruin.

11 ACTIVE MANAGEMENT IS NECESSARY

Active management of tail hedges might seem to be a contradiction in terms since
we are used to hedges being relatively static. But the static approach does not work
when controlling portfolios against tail events. First, as we have highlighted above,
costs are highly variable. Second, counterparty risk is a real risk and its management
is critical to a tail hedge portfolio since the counterparty has to be around to make
you whole on the bought insurance. There are many risks with such contracts, and
not controlling portfolios against failure to pay is a recipe for disaster. For instance,
many participants found that insurance written by monoline insurers was not as
solid as they had thought. Third, transactions costs are asymmetric: when there is
a crisis people are willing to pay the asking price more readily. In our experience,
the fact that tail risks are accompanied by deleveraging has skewed the transaction
efficiency to the part that is long the hedges, ie, when there is a demand surge, the
seller of reinsurance is the price setter for liquidity. This knowledge helps reduce
the frictions on a hedge portfolio when implemented in a disciplined manner over
time. In addition, active management opens up opportunities to add pseudo-alpha
(value that reduces the cost of the hedge) as markets segment and create short-term
dislocations. Since hedges are usually implemented through derivatives, another key
issue is one of financing: for out-of-the-money equity options and foreign exchange
options, the payment is usually made up front. On the other hand, for credit deriva-
tives, the payment is as you go, and it is possible to build in a substantial degree
of notional leverage. Staying on top of these micro elements of the hedging market
can make all the difference between a tail hedge approach that works and one that
does not.

12 CONCLUSION
In this paper I have offered some perspectives on tail-risk hedging from an investors
perspective. The essential insight is that tail risks for typical diversified portfolios
are a result of systemic risks and rising correlations. Thus a proper tail-risk hedging
program takes into account the relative pricing of broad macro markets and strate-
gies and evaluates the best alternatives from combinations of these alternatives to
immunize the portfolio against improbable but not impossible shocks.

REFERENCES
Bhansali, V. (2007a). Markowitz bites back: the failure of CAPM, compression of risky
asset spreads and the path back to normalcy. PIMCO Viewpoints, Spring 2007.

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Bhansali, V. (2007b). Putting economics (back) into quantitative models. Journal of Port-
folio Management 33(3), 6376.
Bhansali, V. (2007c). Volatility and the carry trade. Journal of Fixed Income 17(3), 7284.
Bhansali, V. (2008). Correlation risk what the market is telling us and does it make sense?
In Credit Risk: Models, Development and Management, Wagner, N. (ed.). Chapman and
Hall, Boca Raton, FL.
Bhansali, V., and Wise, M. B. (2001). Forecasting portfolio risk in normal and stressed
markets. The Journal of Risk 4(1), 91106.
Bhansali, V., Gingrich, R., and Longstaff, F. A. (2008). Systemic risk, what is the market
telling us? Financial Analysts Journal 64(2), 1624.
Fung, W., and Hsieh, D. A. (2001). The risk of hedge fund strategies: theory and evidence
from trend followers. Review of Financial Studies 14(2), 313341.

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