Antuireann Risk Management

The idea of risk management is to provide some protection during adverse events. However, the cost of that protection must be balanced against the benefit. For example, in a strategy that uses costly long put options to eliminate the downside, the portfolio’s return should not be greater than the risk-free rate. By contrast, we focus on the idea of crisis alpha, which uses dynamic methods that lower risk and also preserve excess returns. In this sense, they provide alpha when it is most needed—during crisis periods.

Trend following is one technique that works especially well with a crisis-alpha strategy. Theoretically, trend-following strategies sell in market drawdowns (mimicking a dynamic replication of a long put option) and buy in rising markets (mimicking a dynamic replication of a long call option). This resembles a long straddle position and induces positive convexity. While it is possible to purchase the long straddle directly, that is expensive. Implementing a trend-following strategy is not expensive, but it is not as reliable as taking option-based insurance.

The two most basic parameters of the return distribution are average return and standard deviation of returns, but investors do not necessarily limit their interest to these. Rather they may also care about the asymmetry of the return distribution and may be particularly averse to occasional large negative returns. In other words, investors may dislike negatively skewed return distributions and be drawn to positively skewed return distributions.

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In the late stages of long bull markets, a common question arises: What steps can an investor take to mitigate the impact of the inevitable large equity correction? Hedging equity portfolios is notoriously difficult and expensive. The typical investment portfolio is highly concentrated in equities, leaving investors vulnerable to large drawdowns. Long gold and long credit protection portfolios sit in between puts and bonds in terms of both cost and reliability. Dynamic strategies that performed well during past drawdowns include futures time-series momentum. Passive option protection seems too expensive to be a viable crisis hedge.