Chasing Your Tail Risk

There are many people out there following aggressive investment strategies, but they want to be covered if things go wrong.  Why not sell down the positions a little and buy some high quality short-to-intermediate-term bonds?

What!?! Give up the upside?!  They would rather buy some insurance — something that will pay off big if things go bad.

But think of the other side of the trade.  What does the one offering you insurance have to do?  It depends if they are scrupulous or unscrupulous.

Scrupulous: Set aside money or high quality assets in reserve, and treat the premiums as part of the the return on a high-yield money market fund, albeit with the possibility of a severe loss.

Unscrupulous: Don’t set anything aside.  Write as many contracts as you can.  It’s free money because there won’t be any crash.  And if there is a crash, declare bankruptcy.  After all, many others will be doing the same thing — you will have company.

Even if the contracts in question are exchange-traded, with margin posted, still the one writing the contracts and taking the risk should be ready to pay the whole wad in the disaster scenario.  Maybe the exchange will make up a few small defaults, but even exchanges can go broke if the situation is severe enough.

In order for tail risk to be mitigated fairly, someone must keep a supply of slack high quality assets.  Rather than the insurer doing that, why not have the investor do so?  The insurer brings along his own cost structure.  Why not self insure and bring down the risk level directly.  Someone has to hold high-quality assets to mitigate risk; let the investor be that party; embracing simplicity and enjoying reduced risk without the possibility of counterparty failure.

Quaint, huh?  And it doesn’t involve a single disgusting derivative, unlike those that would create a “Black Swan” ETF.