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06/23/2011

Robert Litterman: Who Should Hedge Tail Risk?


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CFA InstituteIn a somewhat ironic turn of events, many investment banks began selling insurance against equity tail risk to institutional investors following the financial crisis. Ironic because one might expect that investment banks, with high leverage and quarterly earnings reports to worry about, would be the natural buyers of such insurance and long-horizon investors the natural sellers.

Surely, those with deep pockets and long horizons, who would be little affected by the crisis, should be selling insurance to those with short horizons and leveraged positions, who would be most highly affected.

Of course, there will always be a price low enough that a given investor would be willing to buy insurance, and there will always be a price high enough that the same investor would be willing to sell insurance. But investors who have long horizons, sufficient liquidity, and low leverage should consider carefully whether, in practice, the price at any given time is low enough that buying tail-risk insurance makes sense for them. That scenario is unlikely because long-horizon investors are not natural buyers of tail-risk insurance.

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