Why Is Portfolio Protection So Expensive?

The post-2008 stress tests may have something to do with why portfolio protection is so expensive, but it can't be the only reason

by Adam Warner

Published on Dec 10, 2015 at 9:17 AM
Updated on Dec 10, 2015 at 4:06 PM

It's natural that downside protection costs more than a hedge against an identical upside move. Part of that is thanks to human nature. We're simply wired to hate losses more than we "enjoy" gains. Greed is "good," but risk aversion rules the roost.

The major reason, though, is that the world is simply net long. There's just naturally more demand to hedge downside than upside.

So the fact that we see the world at large pay "up" for puts, and for derivatives like CBOE Volatility Index (VIX) futures, makes perfect sense. There are many ways to gauge "skew," but all suggest it's just a question of the degree that investors pay up.

What's noteworthy now is the degree to which the investing world pays up. By all accounts, it's as high as ever, especially in the context of the actual risk. Bloomberg has a very interesting theory here about what's going on:

"For more than a year, dealers in the U.S. equity derivatives market have noted a widening gap in the price of certain options. If you want to buy a put to protect against losses in the Standard & Poor's 500 Index, often you'll pay twice as much as you would for a bullish call betting on gains.

"New research suggests the divergence is a consequence of financial institutions hoarding insurance against declines in stocks.

"... While various explanations exist including simply nervousness following a six-year bull market, Deutsche Bank AG says in a Dec. 6 research report that the likeliest explanation may be that demand is being created for downside protection among banks that are subject to stress test evaluations by federal regulators. In short, financial institutions are either hoarding puts or leaving places for them in their models should markets turn turbulent."

In other words, blame the post-2008 stress tests! I can't prove or disprove any of this theory, but it does make some sense.

But here's the flip side. It suggests there's some serious asset mispricing going on. There's a subsector of the financial world that essentially takes the other side of this trade. In 2015, it's mainly hedge funds, but it's essentially available to anyone willing to become a de facto insurance company and take on more risk.

"Tails" are overpriced. Over time, selling puts, selling VIX futures, etc. should work under those conditions. Way smarter minds than yours truly know this quite well, and surely put on variations of this all the time. The greater the overpricing, the more demand there will be to try to fade the "tails."

That's a long-winded way of saying it's an interesting theory, but there has to be an equilibrium somewhere, at some price. The increased natural demand for protection from banks certainly increases that price, but it can only explain so much about what's going on.

Are risks higher than we commonly think? Or, better, is perceived risk higher than we think? Tough to know, but it sure seems like at the end of the day, there really is a higher fear factor out there.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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