Even More Tail Risk

• Posted by Adam Warner
• on July 30th, 2010

Looks like even Warren Buffett has felt the sting of some Tail Risk (feel free to insert Becky Quick jokes in the comments). This from Bloomberg.

A bullish stock market trade embraced by the smartest money is backfiring. And that has investors wondering if what Warren Buffett and Goldman Sachs Group Inc. know about derivatives is obsolete.

Goldman Sachs, the world’s most profitable securities firm, reported losses from derivatives last quarter after selling insurance that protected clients against stock swings during the Standard & Poor’s 500 Index’s biggest retreat in more than a year. Buffett, the chairman of Omaha, Nebraska-based Berkshire Hathaway Inc., underwrote $37 billion of the contracts since 2004, filings with the Securities and Exchange Commission show.

The combination of hedging by insurance companies, tighter regulation of bank speculation and reluctance among securities firms to write derivatives known as variance swaps means speculators who sold them are now facing losses, according to Morgan Stanley and Societe Generale SA. Money-losing trades in both rising and falling markets show the hazards of the business for even Wall Street’s most sophisticated investors.

“It’s as extreme as I’ve ever seen,” said Neil Davies, head of structured equity products at SunTrust Robinson Humphrey Capital Markets in Atlanta. “There’s a lot of uncertainty in the over-the-counter volatility market, illustrated by the fact that long-dated volatility levels are reminiscent of October 2008. Rumors abound, specifically that some institutions are closing out short positions.”

I believe when they refer to “insurance” it’s that gigantic long dated put sale that Buffett made a few years back.

In any event, we keep hearing variations of this story. OTC products upstairs that gets the pro’s short some de facto equivalent of puts far away in both time and price. Something very very tough to hedge.

This is clearly what’s spilling out into the markets in the form of high skew and a steep VIX term structure. And it looks like it’s here to stay, a friend of mine with knowledge of these variance products they trade upstairs thinks this takes 5 years to play itself out. We’ll see.

But hey, there’s help on the way! Sort of. Direxion listing some dynamically hedged volatility products as Bill Luby notes.

Credit Direxion with being the first to venture into the realm of actively managed ETFs with a strong volatility component. In a recent SEC filing, Direxion unveiled plans to launch an intriguing new ETF under the name of S&P 500 Dynamic VEQTOR Shares. This ETF will seek to track the S&P 500 Dynamic VEQTOR Index, which was launched by S&P back on November 18, 2009.

So far, so good.

Here is where it gets interesting. The VEQTOR index (and ETF) have three components: equity (S&P 500); volatility (S&P 500 Short-Term VIX Futures Index, aka VXX) and cash. Based upon several rules and formulas, the index attempts to derive – on a daily basis – the ideal target volatility allocation. This is accomplished by evaluating realized volatility and implied volatility, determining the implied volatility trend (using 5-day and 20-day IV moving averages) and arriving at a target index volatility allocation based on realized volatility and implied volatility data. Once the target volatility allocation has been determined (the range is from 2.5% to 40.0%), the balance of the index is populated with the S&P 500.

This apparently attempts to replicate a dynamic hedging vehicle bandied upstairs already. To the best of my recollection this product (the name escapes me, but it sounded like CDO or CDS) leveraged up into rallies and deleveraged into declines automatically. If that sounds like the Portfilio Insurance Time Bomb of 1987, well……that’s how it sounded to me too.

My general thought is that if everyone’s buying tail risk insurance, than it makes tails less likely to happen. But of course, someone’s always short the “tail risk”, so it can snowball too.

All in all, lots of drivers out there that work their way into our space.

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