Do Hedge Funds Hedge? New Evidence from Tail Risk Premia Embedded in Options

This paper deciphers tail risk in hedge funds from option-based trading strategies. It demonstrates tradable tail risk premia strategies as measured by pricing discrepancies between real-world and risk-neutral distributions... [ view full abstract ]

This paper deciphers tail risk in hedge funds from option-based trading strategies. It demonstrates tradable tail risk premia strategies as measured by pricing discrepancies between real-world and risk-neutral distributions are instrumental in hedge fund performance, in both time-series and cross-section. After controlling for Fung-Hsieh factors, a positive one-standard deviation shock to volatility risk premia is associated with a decline in aggregate hedge fund returns of 25.2% annually. Results evidence hedge funds that load on volatility (kurtosis) risk premia subsequently outperform low-beta funds by 11.7% (8.6%) annually. It suggests to what extent hedge fund alpha arises from selling crash insurance strategies.