The value of tail risk hedging in defined contribution plans: What does history tell us

Basu, Anup K. & Drew, Michael E. (2015) The value of tail risk hedging in defined contribution plans: What does history tell us. Journal of Pension Economics and Finance, 14(3), pp. 240-265.

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Hedging against tail events in equity markets has been forcefully advocated in the aftermath of recent global financial crisis. Whether this is beneficial to long horizon investors like employees enrolled in defined contribution (DC) plans, however, has been subject to criticism. We conduct historical simulation since 1928 to examine the effectiveness of active and passive tail risk hedging using out of money put options for hypothetical equity portfolios of DC plan participants with 20 years to retirement. Our findings show that the cost of tail hedging exceeds the benefits for a majority of the plan participants during the sample period. However, for a significant number of simulations, hedging result in superior outcomes relative to an unhedged position. Active tail hedging is more effective when employees confront several panic-driven periods characterized by short and sharp market swings in the equity markets over the investment horizon. Passive hedging, on the other hand, proves beneficial when they encounter an extremely rare event like the Great Depression as equity markets go into deep and prolonged decline.

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ID Code: 78127
Item Type: Journal Article
Refereed: Yes
Keywords: tail risk, active hedging, options, monetization, risk management
DOI: 10.1017/S1474747214000225
ISSN: 1474-7472
Divisions: Current > QUT Faculties and Divisions > QUT Business School
Current > Schools > School of Economics & Finance
Copyright Owner: Copyright 2014 Cambridge University Press
Deposited On: 29 Oct 2014 23:52
Last Modified: 23 Jun 2015 02:45

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