| Portfolio Insurance (PI) is a growing business. The leading vendor of portfolio insurance has seen its business grow from about {dollar}500 million of protected assets to over {dollar}6 billion of protected assets in a little over two years.; A lot has been written about PI, and myths abound both in the investment community and academia. This paper analyzes some of the approaches to PI with a view to determining how PI can be created and what are its characteristics. Various forms of PI are discussed and evaluated.; The paper begins with a brief review of some PI strategies that have been used in the past. The great potential of Hakansson's Superfund concept for PI then is presented: with some original work on the pricing of Hakansson's Supershares, and generalized european options. This work is related to PI, and the attractiveness of this vehicle as a system for delivering PI and other types of payoff patterns is established.; The paper presents a unique discussion of PI in the context of the Black-Scholes option pricing model. Among other things, a derivation of the long run compound annual return of a synthetic put PI strategy is presented.; Some real life complexities are addressed: The limitations of a pure Black-Scholes approach are discussed, and some practical solutions are presented. This is followed by a detailed discussion of PI in the context of futures markets. The emphasis is on the characteristics of the hedge losses in relation to the underlying securities portfolio and the behavior of the market. This is important for consumers of PI because they cannot proceed without knowledge of the funds they must set aside for initial and variation margin in their futures accounts. This section also addresses the cross hedge risk between the actual securities portfolio and the instrument underlying the futures contract. The possibility of partially insuring the independent portion of the underlying portfolio's return is discussed, and it is shown how dangerous this strategy can be.; Next, an approach is developed to determining a PI program for an investor preferable to his current uninsured portfolio. It is shown how the investor's expected return can be increased and his perceived downside risk can be decreased, at the same time. These conceptual questions are brought to bear on the problem of devising a PI strategy which has a higher expected return than the S&P500, with no higher perceived downside risk. The theoretical properties of the approach are computed, and compared with the results of simulating the use of the strategy over a recent 56 year period.; PI is compared with Compound Portfolio Insurance (CPI), which corresponds to the use of options on two risky assets. A detailed numerical analysis of the characteristics of both kinds of insured portfolios is presented, and the resulting differences explained. It is made plausible that PI will be preferred to CPI by most investors. (Abstract shortened with permission of author.)... |
