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The value of tail risk hedging in defined contribution plans: what does history tell us*

Published online by Cambridge University Press:  07 July 2014

ANUP K. BASU
Affiliation:
School of Economics and Finance, Queensland University of Technology, Brisbane, QLD 4001, Australia (e-mail: a.basu@qut.edu.au)
MICHAEL E. DREW
Affiliation:
Griffith Business School, Griffith University, Nathan, QLD 4111, Australia (e-mail: michael.drew@griffith.edu.au)

Abstract

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.

Type
Articles
Copyright
Copyright © Cambridge University Press 2014 

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Footnotes

*

The authors would like to gratefully acknowledge the support of Troy Rieck in writing this paper. The paper has benefitted from comments of two anonymous reviewers, Robert Swan, and the participants in the Griffith Academia-Industry Symposium. The authors thank Aditya Maheshwari, Phillip Turvey, and Osei Wiafe for providing excellent research assistance.

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