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Digital Subscriptions > The Hedge Fund Journal > Issue 113 - April | May 2016 > Volatility and Tail Risk Investing

Volatility and Tail Risk Investing

Managers and investors consider a new environment for risk

The debate over volatility as an asset class has become much noisier of late, in large part because financial markets have entered new territory, but also because volatility trading or investing has started to enter mainstream territory. There are far more investors active in the market than there were 10 years ago, and a wide diversity of players that has been creating more inefficiencies. Part of its popularity has been the arrival of the post-2008 low growth environment, coupled with the opportunity to hedge tail risk with volatility-based products.

A new economic conundrum has also got investors concerned. Today, as Paul Donovan, global economist with UBS Investment Bank, recently pointed out at the annual London Volatility and Tail Risk Hedging Educational Event, it is less a question of the collapse of trade globalisation, and more a case of the collapse of capital flows (now at 6% of global GDP versus 20% in 2008). This is being partly driven by the regulation that effectively forces banks to bring capital closer to home, for example through the implementation of more aggressive capital controls. Donovan noted that the capital flows that have been most affected are those into debt and equity markets, creating a drain on market liquidity. “As local markets are being regulated more aggressively, creating captive investment pools, market rates of return have collapsed,” he says

The situation is being exacerbated by the buy and hold mentality of many investors, particularly in the wealth management sector: their appetite for corporate bonds, prompted by the quest for income, is further reducing liquidity, along with a variety of other factors.

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