Behavioral Perspectives on Tail-Risk Hedging

Abstract

Various aspects of tail-risk hedging are explored from a behavioral perspective. We first demonstrate that a myopic approach to tail hedging that does not properly account for the value of the hedging in the full portfolio context can overlook its benefits. We also address the overpricing of deeply out-of-themoney puts in the context of a behavioral model and show that the skew can be rational and persistent within these models for a wide range of reasonable parameters. In addition, we show how in the presence of investors who prefer more skewness to less, negative expected return tail hedging can be perfectly rational, even in the presence of other investors for whom tail hedging is not optimal. Finally, we discuss how tail hedging overcomes time inconsistency in investor behavior and thus can be used as a precommitment device.

TOPICS: Tail risks, options