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The Value of Tail Risk Hedging in Defined Contribution Plans: What Does History Tell Us
Company: Journal of Pension Economics and Finance
Company Url: Click here to open
Year Of Publication: 2014
Month Of Publication: July
Resource Link: Click here to open
Pages: 1-26
Download Count: 0
View Count: 945
Comment Num: 0
Language: English
Source: article
Who Can Read: Free
Date: 7-26-2014
Publisher: Administrator
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.
Basu, Anup K Sign in to follow this author
Drew, Michael E. Sign in to follow this author
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