Question with regards to section 7.6 (page 283) of book 3. The investor is hedging an expected increase in equity market volatility and he decides to buy a call and sell a put (long risk-reversal).
The question, how can he hedge tail risk by taking advantage of increase in volatility while lowering his hedging costs?
Why we use long risk-reversal? How is this hedging tail risk? We just sold a put so we’re exposed to downside risk are we not? The entire position of buying a call and selling a put would be advantagious if the market goes up.
If the price drops you gain on your original position, the short stock, and you lose (your gain is limited) on the derivative, actually the short put.
He hedges tail risk in the way that he mitigates the potential loss of the original position (the short stock in this case), and gives up some of the potential upside. So his position will not be that much volatile.
The cost of a risk reversal will be smaller than that of a pure option because one option fee paid but the other received.
I don’t have 2020 curriculum, so can’t check but does this help?