Hedging Extreme Co-Movements

TL;DR

This paper introduces a method to calibrate extreme tail dependence between assets and factors, demonstrating that portfolios with minimal tail dependence can decorrelate from the market without sacrificing performance.

Contribution

It presents a new calibration technique for extreme tail dependence and shows how to construct portfolios that minimize tail dependence while maintaining performance.

Findings

Portfolios with minimal tail dependence decorrelate from the market.

Calibration method for extreme tail dependence is effective.

Minimal tail dependence portfolios retain Sharpe ratio performance.

Abstract

Based on a recent theorem due to the authors, it is shown how the extreme tail dependence between an asset and a factor or index or between two assets can be easily calibrated. Portfolios constructed with stocks with minimal tail dependence with the market exhibit a remarkable degree of decorrelation with the market at no cost in terms of performance measured by the Sharpe ratio.