Strategies · Library · Distressed assets
§15.3.1Factor
Distress risk puzzle – risk management
A variant of §15.3 Distress risk puzzle
The healthy-minus-distressed spread loses badly when markets rebound after a crash. Scale the position by target volatility divided by volatility realised over the prior year to limit those losses.
- Asset class
- Distressed assets
- Held for
- Months
- Data
- ARCANE has part of the data
- Symphony
- Cannot be built as a symphony
The rule
- Signal
- Realised volatility of the spread over the past year against a target of about 10 to 15 percent
- Entry and exit
- Same rebalance as the base strategy; size up or down as volatility changes
- Sizing
- Exposure equals target volatility over realised volatility, optionally capped at 100 percent
How it fails
- Spread itself needs bankruptcy models
- Vol estimate lags
- Leverage if uncapped
Data it needs
- company fundamentals
- stock prices
Prices yes, fundamentals no.
How ARCANE uses it
Shows how Alpha could size a position down when recent volatility is high. Paper only.
Needs the long-short spread as the underlying series.
Filed under the factor card
Own companies that are small, cheap, profitable and invest conservatively, against their opposites, and rebalance once a year.
A paper plan from this card holds 63 to 365 days, stops at 2× the expected move and uses at most 75% of your risk budget. The card
Source: Kakushadze and Serur (2018), 151 Trading Strategies, §15.3.1, p. 110 of the SSRN version. Described in our words. Factor is ARCANE’s filing, not the book’s.