Long tail risk refers to the tips of the bell curve that are more than two or three standard deviations from the mean. Tail risk hedging refers to hedging against events that have extremely low probability.
Morgan Stanley first pitched the idea of an out-of-the money two year/one yearreceiver swaption denominated in Aussie dollars earlier this year after it did researchon the most effective and cheapest tail risk hedges in Asia. Since then, Hjort said some Asian hedge funds that have typically been equity-only or macro hedge funds who invest predominately in equities have entered interest rates to put these hedges on.
This trade involves buying a swaption with a two-year option for a one-year swap at a lower strike than the current forward prices. The buyer of this swaption would receive the fixed rate if the option were exercised. The historical performance of the effective exchange rate (REER) for both the [Australian dollar] and [Korean won] are closely linked to Chinese growth, a MS research report reads, citing Koreas exposure to China in machinery and vehicles and Australias exposure via commodities.
According to Hjort, an analysis across asset classes showed Aussie dollar interest rates to be the cheapest hedge with the highest risk/reward scenario. In our hard-landing scenario, we find leverage or cost-adjusted payout is above 10x, which is around 2.4x that of fx or equity options markets, something we find compelling, the research report reads. The analysis of the same swaption in Korean won showed a cost-adjusted payout of only 4.3x. Names of hedge funds that put on these trades could not be gleaned.