Introduction

Financial turmoils are most often marked with series of sharp falls in asset prices triggered by certain market events, with the recent examples of the S&P downgrade of US debt, and default speculations of European countries. Many individual and institutional investors are wary of large market drawdowns as they not only lead to portfolio losses and liquidity shocks, but also indicate potential imminent recessions. As is well known, hedge fund managers are typically compensated based on the fund’s outperformance over the last record maximum, or the high-water mark. As such, drawdown events can directly affect the manager’s income. Also, a major drawdown may also trigger a surge in fund redemption by investors, and lead to the manager’s job termination. Hence, fund managers have strong incentive to seek insurance against drawdowns (see, e.g., Burghardt et al. (2003)).