Step 4: Trigger Mechanism
To enhance the performance of the basic “benchmark” tail hedge, we thus introduce the use of a timing indicator or trigger mechanism. The objective in employing a trigger mechanism is to decrease the weighting (and therefore the cost) of the downside hedge in times of quiet markets and to ratchet up exposure in anticipation of a tail event. In our example, we discuss the use of two triggers taken from two asset classes: 1) equity volatility skew; and 2) CDS spreads from the fixed-income markets in the construction of the Credit Suisse Equity Dynamic Tail Hedge Index.
Signal 1 – Skew: Implied equity-market skew is defined as the difference between implied volatility for lower strike options (typically put options purchased for protection) and implied volatility for higher strike options (typically call options purchased for leveraged upside exposure). Historically, during severe market downturns, implied equity-market skew has increased significantly (Figure 5), confirming our choice of equity skew as the primary source of tail protection in Step 3. This may be explained by an increase in demand for downside protection, pushing up implied volatility levels for lower strike levels.
The indicator analyzes the historical distribution of the three-month 80-100 skew on the underlying equity index over the last three months. If the skew level is significantly above the mean, the signal for a distressed market is activated. This indicator has been historically reactive to market events signaling the beginning of a tail episode.
Signal 2 – CDS Spreads: The indicator is linked to the five-year CDS spread of companies for the relevant underlying equity market. If the CDS index is significantly above the mean, the signal for a distressed market is activated. If the CDS index is significantly below the mean, the signal for a distressed market is deactivated. Otherwise, the signal remains unchanged. The indicator captures medium-term risk and is reactive to changes in the macro environment.
The signals just discussed trigger allocations by the Credit Suisse Equity Dynamic Tail Hedge Index to the Credit Suisse Equity Tail Hedge Index, which in turn is long equity-market skew.
To drive the allocation between cash and the index, the two signals are run daily:
- If one of the signals is switched ON, 50 percent of the exposure is allocated to the CS Equity Tail Hedge S&P Index, the index described at Step 3.
- If both signals are ON, 100 percent is allocated to the hedge index. If neither of the signals is ON, 100 percent is invested in cash (U.S. federal funds rate or EONIA).
Historically, at least one of the signals has been ON for 31 percent of the time period. Typically, a distressed macro environment would first activate the CDS signal, indicating that the likelihood of a tail event has increased. The skew signal would activate when the market crisis gains momentum and equity skew breaks out of range.
This exact methodology is also applied using the Euro Stoxx 50 as an underlying, where the child index (Credit Suisse Equity Dynamic Tail Index) allocates to the parent index (Credit Suisse Equity Tail Hedge Index), based on Euro Stoxx 50 skew and European CDS prices.