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TAIL RISK HEDGING: Creating Robust Portfolios for Volatile Markets by Vineer Bhansali

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5

Indirect Hedging and Basis Risk1

In previous chapters we discussed our macro approach to tail risk hedging, the gains to portfolio performance from tilting the hedged return distribution toward a slightly more aggressive posture, and the critical role of active tail risk management. In this chapter we extend this work to an understanding of indirect strategies and the tradeoff between cost savings and basis risk such strategies entail.

To motivate this, note that because credit and equity are fundamentally related by virtue of their dependence on the profitability of the company issuing them, a catastrophic sell-off of a firm’s equity would result in increasing leverage of the company’s balance sheet. This increased leverage would result in ...

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