Is Fat Tails Insurance Worthless?

Tyler Durden's picture

Regular Zero Hedge readers know about our fascination with fat tail insurance, which is particularly relevant in modern day central planning when nothing is as it should be and everything is as the central bankers determine it is, at least until such time as the general market calls their bluff and we see the kinds of six sigma dislocations that marked trading for months on end after the Lehman bankruptcy. Probably the best most recent example is our overview of the 5 black swans that keep Dylan Grice up at night, and the way to hedge against them (incidentally, these were Long-term deflation, a Chinese Hard Landing, Asset Bubbles, Hyperinflation, and of course, a Bond Market Blow-up). And while one should always be hedge against prevailing conventional wisdom, because more often than not the crowd is wrong, and with very disastrous consequences, GMO's James Montier, in a just released white paper asks the fundamental question (whose affirmative answer could put purveyors of fat tail insurance such Nassim Taleb's Universa fund out of business), whether fait tails insurance is even necessary if everyone is protecting for the very same selection of "black swans" (therefore confirming that the hedged against events are anything but a black swan). Specifically, in Montier's words: "Tail risk protection appears to be one of many investment fads du jour. All too often those seeking tail risk protection appear to be motivated by the fear of missing out (not fear at all, but greed). However, the surge of tail risk products may well not be the hoped-for panacea. Indeed, they may even contain the seeds of their own destruction (something we often encounter in finance – witness portfolio insurance, etc). If the price of tail risk insurance is driven up too high, it simply won’t benefit its purchasers." His solution for the best tail hedge: cash. "In many situations, cash is a severely underappreciated tail risk hedge." And somewhat more philosophic: "When it comes to timing tail risk protection, a long-term value-based approach and an emphasis on absolute standards of value, coupled with a broad mandate (a wide opportunity set, or, investment flexibility, if you prefer) seems to offer the best hope." Too bad that one must also factor for career risk, which usually means that everyone does end up doing precisely the same trade no matter what, which ultimately brings everyone back to square one.

While Grice's paper on the nuances of actual hedging to various strategies is far more detailed, here is how one approaches this topic in Montier's world:

We are aware of three general groups of tail risk protection from which investors may choose.

1. Cash

This is perhaps the oldest, easiest, and most underrated source of tail risk protection. If one is worried about systemic illiquidity events or drawdown risks, then what better way to help than keeping some dry powder in the form of cash – the most liquid of all assets. (There is much more on the joy of cash to come shortly.)

2. Options/contingent claims

Occasionally, the market provides opportunities to protect against tail risk as a by-product of its manic phases. A
prime example was the credit default swaps that were a result of the demand for collateralized debt obligations.
These instruments were priced on the assumption that there would be no nation-wide decline in house prices, and thus offered a great opportunity (even without the benefit of hindsight) for those who were concerned that such an outcome was more plausible than the market thought.

Here, one caveat stands out above all others: one must be cautious of the dangers of over-engineering in this area of tail risk protection. It is too easy to construct an option that pays out under a very specific set of circumstances, and to do so relatively cheaply. But, of course, such an instrument tautologically only pays off under the realization of those specific events, so the tighter the constraints imposed, the less use the option is likely to be as general tail risk protection.

3. Strategies that are negatively correlated with tail risk

For the specific type of tail risk (illiquidity events) under consideration here, long volatility strategies are often said to
be negatively correlated. The simplest example of such a strategy is just to buy volatility contracts (bearing in mind
the roll return will be negative given the upward-sloping term structure of volatility). In the recent crisis, a dollar-neutral long quality/short junk portfolio acted very much like a long volatility strategy (with the added benefit of an expected positive return, in contrast to most insurance options).

Why Montier is skeptical: in one phrase - tail risk herding, driving up the price of hedges.

Tail risk protection is not a magic bullet. The cost of tail risk insurance becomes very evident when compared to the more conservative equities plus cash strategy considered in the sample above. This highlights one of the most important lessons of the exercise: tail risk protection requires timing … the “when” of tail risk protection, if you will. In the sample above, running permanent tail risk insurance similar to that of Strategy 4 leads to what might be called deferred drawdowns, made clear in Exhibit 3.

Obviously there is much more to Montier's thinking which can be found in the full letter below, although we would make one caveat: in tail risk insurance, like in everything else, it only pays to put a trade on if one is early, and, needless to mention, if the trade is the proper hedge against the specific risk. If either of these two are off the table, the naturally the costs will be prohibitive. Alas, in this day and age when alpha is all too often ignored at the expense of levered beta pursuits, in which the investing community has realized the banker trick that it only pays to be wrong if everyone is wrong (and thus will need a government bailout if all fail at the same time), do not expect much original and independent thought. After all - in a regime of centrally planned Bernanke put-ism, the only thing that matters is economies of scale. Whether one is right or wrong, when there is no risk of failure, is completely irrelevant.

Full Montier paper:

Tail Risk Protection Montier

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traderjoe's picture

'The joy of cash'?

Certainly one always wants to maintain some 'liquidity' - in my mind an ability to make it through a particular set of circumstances without having to sell any particular asset under unreasonable conditions and/or terms. 

But if the centrally planned fiats blow up, as I think they will - the only hedge will eventually be to own productive hard assets (unleveraged) and stores of value. And, of course, timing will be everything. But getting productive assets under contract and purchased takes time. Even precious metals purchasing takes time. What will the timing of the crack-up-boom be?

In short, I personally believe timing the flip from deflation to inflation will not be possible. It's best to position now for the other side, and use the time the PTB is allowing us to convert money away from FRN's. That's what I believe they are doing. In the end, the counter-party risk of the FRN is far too high for me. 

Bad Asset's picture

Glenn Beck just dropped

Idiot Savant's picture

Junked for mentioning Beck and ZH in the same breath.

Libertarians for Prosperity's picture

Anyone hear Peter Schiff last week call out Glenn Beck for ripping people off with Goldline?  

Seems like Schiff is going after all the charlatans and frauds recently.


rsnoble's picture

I don't suppose any of you have done a google search lately on the Nebraska nuclear plant flood bern collapsing?

After fukusalla, should we believe any of their crap?  I'm only 250 miles downwind from this sack of shit thus my concern.

NotApplicable's picture

Which I saw before going to bed last night, making my dreams more interesting than ever.

trav7777's picture

too bad you didn't invest in a portable bugout ranch.  Oh wait, there is no such thing

HelluvaEngineer's picture

I'm gonna need more Effen vodka

hedgeless_horseman's picture

Those sure are funny looking black swans circling over Timmy.

akak's picture

If only .....

But vultures only attack and feed on the dead, you know.

They will have to be content with feeding on Timmah's cranium for right now.
The rest of him will be available to them in due course.

buzzsaw99's picture

the last hundred words are pure gold. one other thing, the bernank put/counterparty bailout equipment only works if you are the squid et al. the levered beta players who aren't the squid could be up chit creek sans paddle pdq.

slewie the pi-rat's picture

cash?  did he actually say cash?


Bob Sacamano's picture

Am thinkin the definition of a true Black Swan event will not include any event being widely discussed here or in other media......

NotApplicable's picture

I manage fat tail risk by keeping my fat tail out of risky positions.

JimRogers's picture

Nickels bitches!

gwar5's picture

Dirty Rotten Shame

russwinter's picture

More than a rhetorical question, but where and how does one safely store large quantities of cash. I don't consider under a mattress or in a tin can buried in the backyard an option.

Money Market Funds: Run don't Walk:

gangland's picture

long post but worth it, tried to edit for length but decided just to post half of the column.

it is worth reading another prespective and it is a good summary of the many posts TD strings together one after another here on ZH, though you may just want to read the highlighted sections.



Red alert
Commentary and weekly watch by Doug Noland

Last week provided added confirmation of the bear thesis, although with interesting twists. While Greek Prime Minister George Papandreous' government survived a no-confidence vote, this positive development provided little reprieve for the marketplace.

Contagion jumped the fire line thought to reside at Spain, as Italy arose as a cause for concern. Moody's lowered its outlook on 13 Italian banks and warned that 16 others were vulnerable to credit ratings downgrades. The Italian bank sector was pummeled on Friday, with some of the leading stocks down as much as 5%. Credit default swap (CDS) prices spiked dramatically throughout the Italian banking sector the past two sessions. In reference to

signals of financial stability, European Central Bank president Jean-Claude Trichet admitted things had turned to "red alert". The eruption of systemic risk within Italy should be viewed as a serious debt contagion escalation.

Following a warning the previous week of a possible sovereign debt downgrade, Italy's 10-year sovereign yields jumped 16 basis points (bps) last week to 4.97%. Yields were up 35 bps in three weeks to the highest level since early March. Perhaps more noteworthy, Italian two-year yields spiked 24 bps as the week drew to a close to 3.27%, the high since late 2008. The price of Italy CDS jumped 34 bps in two days to surpass 200 bps for the first time since January. Spain's two-year yields jumped 21 bps this week to 3.66%, the high since early January. Ireland saw its 10-year yields jump 57 bps to a record 11.72%, as Portuguese yields surged 50 bps to a record 11.11%.

Greek contagion fears now cast quite a pall. There were indications of ongoing de-risking and de-leveraging. The energy and commodities sectors suffered another tough week, and the leveraged players certainly can't feel better about the world. And it is an important part of the thesis that a debt crisis induced tightening of financial conditions will particularly weigh on those economies suffering structural short-comings. Italy fits the bill.

At 119%, Italian debt as a percentage of gross domestic product (GDP0 is second only to Greece (143%) in the eurozone (according to Bloomberg data). In the best of market times, this debt appears sound; in the worst, its non-productive and a huge problem. Fortunately, a highly accommodative global marketplace has to this point made Italy's heavy debt-load manageable. At about 5%, Italy's annual deficit has looked favorable relative to many countries in and outside the region. And with Italian banks having limited exposure to periphery debt, the market had believed the sector was largely immune to the crisis.

Yet Italy today hangs very much in the balance. Contagion fears are pushing up Italy's market yields, risking a problematic jump in future debt service costs (and deficits). And as was demonstrated in Greece, when market sentiment changes and things turn sour ... The Italian system now confronts market, political, economic and social uncertainties these days associated with additional austerity measures. Voting with their feet, the marketplace last week scampered away from the Italian financial sector. A tightening of lending by the markets and the banking sector comes at an inopportune time for the moribund Italian economy. GDP expanded only 1.3% in 2010, this following 2009's 5.2% contraction and 2008's 1.3% drop.

Not dissimilar to the United States of America, Italy's debt mountain (US$2.3 trillion) is sustainable only with decent and persistent economic growth. When global market confidence is running high, liquidity abundant and risk-taking in vogue, envisaging an optimistic scenario comes easily for the marketplace. But when the clouds darken, things turn dismal in a hurry. And when folks become nervous about a debt-laden and structurally challenged economy, they will quickly take a keen interest in capital ratios and the general soundness of that economy's banking system. Economic and debt structures suddenly move to the front burner. That's where we are with Italy, and others, these days, as contagion effects gain important momentum by the week.

The VIX index (the market's estimate of the near-term future volatility of the S&P500) actually declined last week. (Today, Monday's range was 20.27 - 21.82, closed at 20.56) It is interesting to note that at 21.10, the VIX closed on Friday slightly above its one-year average (20.19). The VIX spiked above 37 last July and briefly traded above 30 this past March. It is remarkable that contagion effects, having so hastily arrived at Italy's door, are not provoking a dramatic market response in the equity options marketplace. Clearly, the markets have bought into "global too big to fail". Apparently, the more troubling Greek contagion risks become, the greater the markets' faith that global policymakers will find the necessary resolve to come together and ensure things don't spiral out of control.

I would be remiss not mentioning the notably strong performance by Asian markets last week, a region still holding the potential to underpin (exceedingly unbalanced) global growth. And, curiously, from the Financial Times: "Chinese premier Wen Jiabao has declared victory over domestic inflation [in an op-ed piece in Friday's FT], saying that the government has successfully reined in price pressures. 'China has made capping price rises the priority of macro-economic regulation and introduced a host of targeted policies. These have worked ... We are confident price rises will be firmly under control this year.'" (lulz)

Well, OK. And it would be consistent with my thesis that the unfolding "Greek" crisis tempts the Chinese and others to back away from their rather timid tightening measures, giving an extended lease on life to their dangerous credit bubbles (while further feeding global imbalances). I ponder where the euro would trade today without the market perception that the Chinese are there to provide a backstop bid for European debt and the currency.

I have no doubt that global policymakers will act in ways to try to stabilize the system; I'm just increasingly concerned with unintended consequences. A few examples: European policymakers have, for the most part, reached a consensus view that any Greek debt restructuring must avoid triggering defaults within the expansive CDS marketplace. In the process, such maneuverings come with the high cost of damaging the integrity of this market and, perhaps, derivatives markets more generally.

Why purchase insurance if politicians and political pressure can come to bear on the fulfillment of future contractual obligations?
Elsewhere, politicians can release oil reserves and at least temporarily reduce energy prices for the benefit of consumers and economies. Yet, in an age of highly speculative markets, such moves exacerbate market turbulence, risk aversion and de-leveraging.

And as Federal Reserve chairman Ben Bernanke claims that the Fed retains considerable firepower to support the recovery, the marketplace is left to ponder what the devil he has in mind.




jm's picture

People do focus too much on hedging, and they focus too much on extremes.  This is because taking the craziest risks is the name of the game.  I thnk hedging in this situation makes people even more reckless.

The fact of the matter is that you often aren't rewarded for taking extra risk, even over a long term.  If you bought a basket of subordinate European bank debt in 2004, you have made pretty good total return... along with some heart attacks.  If you bought senior debt on the same names, you got almost exactly the same total return with less heart problems.

A more legitimate reason for hedging is in illiquid markets, because you need something that will keep up with margin needs.  Heaven forbid you post shaky collateral and get a massive haircut applied to your position.  Cash often won't help here:  you need something that moves with a meltdown.     

Another hedge is a dealer that won't screw you on an unwind.


ZackLo's picture

Last couple days on have been very strange.....

around 6 o clock both times check out the images..

you wanna talk about fat tails?!

LMAO's picture

It's the brand new Mark to Market App. which they have installed.

It's an app. which shows true real-time market value of the said DJA.

This basically means DJA excluding ZIRP, TARP, QE inf. and other creative accounting machinations.


This was all supposed to be hush-hush financial insider Voo-Doo, until of course some finviz tool accidentally pushed the wrong button.

And there it is, exposed in all it's splendor.


Mercury's picture

Insurance is of course only as good as the counterparty that sells it and their ability to manage their liabilities.  Cash really has been a great hedge against most such "black swans" in the past but if you can't lay your hands on it when you need it or it suddenly becomes worthless (hyperinflation, "red money" etc.), that won't work either. 

Hard assets are nice but depend on might or the rule of law to stay in one's possession.  They also tend not to travel well - I've known a couple of smart, accomplished men who fled Europe in the '30's for Cuba only to have to flee from there in the early '60's -  leaving a lot of accumulated real property and possessions behind in both cases.

Gold is sort of the best of both worlds but to quote The Grateful Dead:

Now I don't know but I been told, it's hard to run with the weight of gold
Other times I've heard it said, it's just as hard with the weight of lead...

No hedge is perfect and besides, on a long enough timeline...


oldman's picture

Zero hedge is freedom

unfortunately freedom does not allow

being off balance

or BIG

camoes's picture

There's no such thing as a black swan protection, because the very nature of it is to be unpredictable ex-ante. Taleb even mentions in his book that the only solution is to be robust, in the case of portfolio management it would be cash/less leverage. But never forget that the black swan may never come at all or the cost of opportunity is high enough that it would have been better off if you had not "protected" yourself.

Even "cash" is subject to a black swan, the currency you hold may be subject to a jump condition devaluation overnight, it has happened before in several countries.

Unfortunately for all the finance theory bashers, Markowitz is still right, the only effective low cost "black swan" protection is to be diversified. But diversification is also relative and subjective. One can say that to be diversified you just need a combination of stocks and bonds, most ZH readers would say guns, canned food and phyzzzz silver bitchez.