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1  Introduction

In March 2020, the coronavirus pandemic hit the financial markets on a scale and speed unparalleled in stock market history. Even the great stock market crashes of 1929 and 1987, and the global financial crisis – seen as a once-in-a-hundred-years event in its own right – have been put in the shade by recent developments, particularly in light of the effects that rapidly fed back into financial markets and the real economy.

It is also important to stress the extreme volatility of financial markets, reflected in significant, short-term up and down movements on stock markets and volatility indices across different markets. For example, the S&P 500 fluctuated in ranges of +/– 9% for several days in succession. The VIX volatility index climbed to over 82 points, surpassing the peak seen in autumn 2008 at the height of the financial crisis.

Chart A/ illustrates the speed and intensity of the current Covid crisis, especially when compared to past market dislocations such as the dot-com crisis, the global financial crisis and the escalation of global trade disputes in late 2018. The chart shows the performance of the S&P 500 Total Return Index in percent in different stress scenarios as a function of time.

The market crises essentially occur at shorter and shorter intervals, which can be explained by the world’s increasing physical and technological connectedness. On the other hand, the increasing volatility dynamics of financial markets are driven by the ever-growing importance of systematic trading strategies, such as trend-following CTAs or volatility-based risk parity funds. Such investment processes often have to reduce their positions when prices drop below certain levels, or when volatility increases rapidly. The problem is further exacerbated by high-frequency or algorithmic traders who turn off their “machines” when stress levels in the financial markets are high, causing liquidity in the market to dry up.

These market dynamics are likely to persist or possibly intensify in the future, leading to both more frequent and more rapid market corrections, such as those seen in March/April 2020. In this context, the question for investors and asset managers is whether such developments – and the associated effects on the market – can be predicted. While many investors were aware of the fundamental risk of a pandemic-induced (financial) crisis even before 2020, predicting the occurrence and magnitude of such an event in the financial market is virtually impossible.

This uncertainty, together with the growing speed of upward and downward market movements, underscores the need for a responsive and robust risk management approach. Hence, it is vital for investors to implement such a risk management strategy, and build a portfolio that is stable and resilient to such unpredictable events.

2  Advantages of an option-based risk management approach

Investors have a wide range of possible risk management approaches, whose aim is to significantly limit the risk for the portfolio, at the lowest possible opportunity cost. However, the goal of this article is not to compare different risk management approaches, and contrast the individual strengths and weaknesses of the respective strategies. Instead, we focus on a derivative risk management approach using put options, while taking an in-depth, critical look at the excessive opportunity costs and risk-return inefficiency mentioned in many publications.

It is basically true to say that hedging an equity exposure over the term of the put option carries opportunity costs in stable or rising markets. The basic idea behind using a put option is to accept opportunity costs in years of calm markets, in order to be protected in years affected by critical and, above all, unexpected market downturns. To protect against such risks – similar to an insurance policy – it is first necessary to pay a premium whose amount depends on the market environment. The more turbulent the current market environment, the dearer the hedge. This suggests that it is better to buy hedging in a quiet market.

But why should an investor pay a premium to acquire the option, when this is not required for many other derivative hedging instruments? On the one hand, the use of a put option can limit the loss – regardless of the speed and extent of the crisis event – to a firmly definable level. This eliminates the need for discretionary hedging and regular investment decisions by the investor during turbulent market phases.

Moreover, in a market stress scenario the option benefits additionally from rising implied volatility (the priced-in risk and thus the value driver of the option). The more severe the market stress, the more volatility increases, and the more the option gains in value. Especially as part of an efficient risk management process, it is essential to consider this additional protective effect in order to reduce hedging costs.

A/    PERFORMANCE OF THE S&P 500 TOTAL RETURN INDEX IN DIFFERENT STRESS SCENARIOS

Source: Bloomberg (respective periods from the time frame in question, September 28, 2007 to September 30, 2020)

By way of illustration: a put option with a hedge level of, say, 20% will limit the losses of the equity investment at maturity to 20% (plus the premium used) if the market declines by 20%. During the term, and with typically rising volatility levels in a stress scenario, the put option has a much more pronounced risk protection effect (see Chart B/). Appropriate modelling and consideration of the volatility increase in stress phases should therefore be included in the hedging considerations, in order to reduce the premium expense.

However, the high opportunity costs of option-based hedging strategies, criticised in many publications, are also partly attributable to very simplistic assumptions. To some extent, this is because of their generally high complexity, and the volume of data needed for such analyses. The high opportunity costs associated with option-based hedging strategies are therefore examined in more detail below.

B/    RISK PROTECTION PROFILE OF A 20% OUT-OF-THE-MONEY PUT OPTION ON THE S&P 500

Source: Bloomberg (valuation date of the option: as at October 31, 2020, term: 1 year, moneyness: 80%, premium: approx. 4.4%). In the case of immediate stress, a volatility increase equal to half the stock market movement was assumed and the option was revalued on the same day. In the case of stress at maturity, the option is revalued at the maturity date, taking the stock market movement into account.

3  Measuring the (opportunity) costs of risk management

In most cases, a risk management strategy is used because the necessary or desired target return is not compatible with the investor’s risk budget or risk tolerance. One of the most common statements in connection with option-based risk management strategies is that a significantly lower return is achieved compared to a pure equity investment. In principle, this statement is initially correct in primarily rising markets without major market slumps. However, it is important to remember that hedging strategies significantly reduce the risk of the investment. It would be like comparing the return of a broad investment grade corporate bond index with the return of an equity investment.

This raises the question of an appropriate benchmark for the option-based risk management strategy. Essentially, this benchmark must be risk-adjusted. To take a specific example: starting with a conservative, primarily European investment portfolio consisting of 40% government bonds, 30% corporate bonds and 30% equities, the overall portfolio risk is to be reduced by an option-based hedge of the equity exposure. Hedging via put options leads to opportunity costs, and thus to a reduction of the expected return, while at the same time limiting the risk of loss.

Chart C/ shows the quantiles of returns for this portfolio, and for the same portfolio but where the equity investment is hedged via a 20% out-of-the-money put option. The option-based hedge reduces losses from –15.1% to –12.1% (measured by the 95% CVaR, i.e. the average loss in the 5% of worst scenarios) with a simultaneous reduction of the expected return from 2.0% to 1.4%.

A fair benchmark with the same risk should be calculated on the assumption that the investor can afford at most the risk of the option-based strategy. Basically, there are many ways to reduce the portfolio risk to the targeted level. However, from a risk-return perspective, only the portfolio on the efficient frontier that generates the highest expected return for a given level of risk makes the most sense. Chart C/ also shows the quantiles of the efficient portfolio. Compared to the efficient portfolio, the option-based hedging strategy has a higher expected average return (1.4% versus 1.1%) with the same level of risk.

C/    EXPECTED PORTFOLIO RETURN AND RISK RATIOS COMPARED

Source: risklab. The portfolio returns were evaluated for 10,000 possible capital market scenarios lying in the future, based on a capital market model for modelling economically sound and realistic performances of the relevant asset classes. Quantiles shown: 1%, 5%, 25%, 50%, 75%, 95%, 99%. Portfolio composition of SAA: 20% German government bonds, 20% European government bonds ex Germany, 30% EMU corporate bonds, 30% European equities. For the SAA with the same risk budget, the portfolio was selected along the efficient frontier

Alternatively, option-based risk management can be used to increase the equity allocation in the portfolio, with the same level of risk. The attractiveness of the option-based hedging strategy compared to the efficient portfolio depends on the interest rate environment, making it very attractive in the current low interest rate environment, due in particular to the risk-return profile of bonds.

Bonds, especially government bonds, traditionally perform two main functions within a portfolio. On the one hand, they offer diversification from equities and similar risks. On the other hand, they are expected to make a positive and stable contribution to the overall return. However, given the extremely low yields and relatively flat yield curves prevailing in the major developed markets, as well as the commitment of policymakers worldwide to maintain supportive monetary policies to ensure economic recovery after the Covid-19 pandemic, the diversification aspect and the stable contribution to portfolio returns no longer (or hardly) pertain. Chart D/ illustrates the lack of diversification provided by German government bonds in particular. However, the zero interest rate policy in the U.S. also limits the diversification effect of U.S. government bonds.

At the current yield level, investors would therefore have to invest a very large proportion of their assets in bonds to achieve the necessary diversification or risk protection. The consequence is an asymmetric risk profile (as yields will probably rise more than they can fall) and a low target return.

When defining the efficient portfolio, CVaR rather than volatility was chosen as the risk measure. Volatility measures the average spread around an expected return, with an assumed symmetry of positive and negative returns, which means that risk potential is underestimated. CVaR is a more suitable risk measure, as it addresses stress scenarios, and also has good statistical features. Furthermore, the volatility risk measure underestimates the risk protection effect of options.

D/    DIVERSIFICATION EFFECT OF U.S. AND GERMAN GOVERNMENT BONDS IN RELATION TO THE GLOBAL FINANCIAL CRISIS AND COVID

The total return corresponds to the percentage change in the index level in the respective quarter. The change in bond yield corresponds to the difference in yields at the beginning and end of the quarter.

Source: Bloomberg (total return indices: ICE BofA US Treasury Index and ICE BofA German Government Index; 10-year bond yields: US and Germany Generic Government Bond 10Y Yield).

4  Reducing opportunity costs by exploiting the volatility surface

Besides the failure to consider an appropriate benchmark, the second critical point in connection with option analyses relates to the static approach which is often chosen. Static option-based analyses assume a fixed maturity and moneyness of the options to be purchased, as well as a fixed roll date (usually at maturity). The parameters are defined based on the pragmatic idea of reducing the complexity of option analyses.

However, to focus single-mindedly on these parameters is to ignore all market information and the dynamics of the options market. Chart E/ shows the implied volatility surfaces of the S&P 500, which represent the priced-in risk, depending on the term and maturity of the option, at two different points in time (quiet market versus stress scenario). Fixing on one point at any time may not be optimal, since the surface and thus the price ratio of the put options to each other may change, sometimes substantially.

Even if the representation of the volatility surface seems simple, it was constructed from several thousand options listed on the S&P 500. Basically, the respective options or different combinations of options may be suitable for representing investors’ various risk preferences. This degree of complexity and the associated, necessary data volumes is one of the main reasons why the assumptions are greatly simplified in most publications. However, choosing among all these combinations to find the most cost-efficient solution should be a key component of an option-based risk management strategy.

Finally, the assumption of the option roll date at maturity should also be critically examined. Rolling at maturity creates a very pronounced timing risk, as hedging costs can be very high at the roll date. Options (especially those that are further out of the money) with very short maturities also have a lower protective effect. This is due to their limited reactivity to changes in stock prices and volatility.

For the reasons discussed above, an option-based hedging strategy should therefore be implemented dynamically rather than statically. With the dynamic approach, the option parameters of maturity and moneyness, the reallocation dates and the build-up and reduction of the hedge are calculated dynamically, taking all information from the options market into account. 

E/    IMPLIED VOLATILITY SURFACES OF THE S&P 500

Source: Bloomberg

5  Regulatory eligibility of options

Finally, it is necessary to address an issue that is essential for many regulated investors, which makes option strategies additionally attractive, but is also rarely mentioned, namely regulatory eligibility. Option-based strategies are generally accepted as risk-mitigating by various regulators such as BaFin or under Solvency II. Thus, by using options, a higher equity ratio can be achieved with the same risk capital, or a significant reduction in risk capital can be achieved with the same equity ratio. Eligibility is typically checked by the regulator on a case-by-case basis.

The basic idea behind using a put option is to accept opportunity costs in years of calm markets, in order to be protected in years affected by critical and, above all, unexpected market downturns.

6  Summary

Apart from the necessary specialist know-how, opportunity costs in a very long bull market are undoubtedly a limiting factor for option-based risk management systems. However, recent turmoil in the wake of the Covid pandemic has once again highlighted the importance of a permanently robust risk management framework. A dynamic option-based hedging strategy provides an answer, offering a possible, attractive concept for investors in the current low-interest-rate environment (with the asymmetric risk-return profile of bonds).

Calculable protection, calculable premium costs and a higher expected return for the same risk are just some of the benefits described. Reduction of the equity coverage (eligibility of equity capital, investment limits) should also be mentioned here, particularly in the case of regulated investors.

Implementing a risk management strategy in the aftermath of a crisis might be likened to taking out fire insurance after the house has burned down. However, for investors who are currently realigning their investment strategy against their SAA objectives, or who do not rule out more rapid and more frequent capital market declines in the future, a higher allocation to opportunity-rich assets by integrating the risk management strategy outlined above can provide a structural advantage.

This article was published in Absolut Report (6|2020)

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