Cost of 'tail risk' protection set to soar

Not so long ago, the idea of "tail risk" was alien to many investors. Now, bruised by the 2008-09 financial crisis, fund managers pay to insure their portfolios against market meltdown. And tough, new regulations mean the cost of that protection could be about to soar.

Investors have learned the hard way about not being prepared for extreme events, be it the subprime disaster, political turmoil in the Middle East or eurozone debt crisis. Demand for buying long dated options and other complex products, such as 10-year variance swaps that compensate for an unexpected future calamity has grown as a result.

The cost of "tail hedging" has retreated from last year's peak when anxiety over the eurozone was at its highest, yet premiums remain elevated and investors fear they could soon climb again.

The fear is that higher capital requirements for banks and the proposed Volcker Rule, which would prohibit banks from engaging in proprietary trading, will limit the ability of Wall Street dealers to support protection against risk and reduce liquidity in products such as variance swaps.

"You can't expect markets to function well if you eliminate incentives for market makers," says Andrew Lo, a professor of finance at the Massachusetts Institute of Technology. "It's the problem of reactive legislation and the Volcker Rule is a good example of the unintended consequences that can come out of Dodd Frank."

While post-financial crisis legislation is aimed at making sure taxpayers are not asked to bail out excessive risk-taking by banks again, the withdrawal of Wall Street support across a range of markets would be likely to result in higher costs of trading for investors.

Dealers warn that if the cost of capital for underwriting tail risk hedges is too high when proposed rules are finalised, they will have little choice but to step aside, resulting in higher costs for institutional investors managing funds on behalf of smaller clients.

"When the next tail event occurs, pension funds and insurers will get hit hard as they have been unable to hedge that risk," says Professor Lo. "This ultimately affects the consumer via the pension and insurance industries, who can't use these instruments to hedge long term risks."

While some say hedge funds and other investors may fill the void left by dealers, the worry is that these new entrants would not arrive until the cost of hedging had risen further.

Alexander Marx, head of global bond trading at Fidelity Investments, told a congressional committee last month: "Security transactions will be more challenging to carry out and there will be negative effects on the investment performance of the funds that individual investors, pension plans, and other institutional investors hold."

That is the last thing tail risk buyers will want to see as they attempt to protect their portfolios amid the current uncertainty in the markets over Greece and other troubled eurozone nations.

The market for 10-year variance swaps on the benchmark S&P 500 index, which track the relative demand for options that pay out in the event of large index moves versus small moves, already suffers from poor liquidity. "The bid and offer is very wide, and when you want to monetise there is no market," says Mr Bergmann.

Some investors instead focus on shorter term insurance, such as options on the CBOE Volatility index, which tend to go up in value as share prices fall. But it is a flawed approach that does not suit their liabilities and means they must "roll over" their protection in future. Insurers, for example, offer retirement products that pay out over many years.

"The price has gone up a lot, so we tend to use more short-dated, even knowing that it doesn't match the liability perfectly," says Sonin Kwon, director of equity risk hedging at MassMutual. "Instead. we're just rolling over short-term options, even though that is much more expensive."

Dealers have become more wary, too, about underwriting tail risk. Not only does this require large amounts of capital to back the insurance, some believe big market-moving events such as the May 2010 "flash crash" on Wall Street are becoming more frequent. Jeff Lowe, head of product development at BNP Paribas Prime Brokerage, says: "When 100 years events happen every two to three years, your internal policies get more thought to make sure you're not left holding tail risk."

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