Introduction

In this chapter, we will explore the concept of portfolio insurance, a risk management strategy used in financial markets. Portfolio insurance is designed to protect an investment portfolio from significant losses during market downturns. We will examine how portfolio insurance is implemented and compare it with the more familiar strategy of delta hedging. By the end of this chapter, you will have a clear understanding of both strategies and their respective advantages and limitations.

Implementing Portfolio Insurance

Portfolio insurance involves using options or other derivatives to protect the value of a portfolio against adverse market movements. The primary goal is to limit potential losses while allowing for potential gains. There are several methods to implement portfolio insurance:

• Put Options: One common approach is to purchase put options on an index or a basket of stocks that closely mirrors the composition of the portfolio. Put options give the investor the right, but not the obligation, to sell the underlying assets at a predetermined strike price. If the market declines significantly, the put options can be exercised to limit losses.

• Dynamic Hedging: Similar to delta hedging, dynamic portfolio insurance involves adjusting the position as market conditions change. In this case, the portfolio manager may increase the number of put options held as the market declines to maintain a certain level of protection.

• Constant Proportion Portfolio Insurance (CPPI): CPPI is a more complex strategy that dynamically adjusts the allocation between risky assets (e.g., stocks) and safe assets (e.g., bonds) based on a predetermined formula. As the value of the portfolio decreases, the allocation to risky assets is reduced to limit potential losses.

Comparison with Delta Hedging

Now, let’s compare portfolio insurance with delta hedging:

• Objective: Delta hedging aims to neutralize the delta (sensitivity to the underlying asset price) of an options portfolio to minimize directional risk. Portfolio insurance, on the other hand, focuses on preserving the overall value of a portfolio by using options as protection.

• Scope: Delta hedging is primarily used for managing options positions, while portfolio insurance is designed for broader portfolio protection.

• Complexity: Delta hedging can be relatively straightforward when applied to individual options. Portfolio insurance strategies, especially CPPI, can involve complex formulas and dynamic adjustments.

• Cost: Portfolio insurance through options can be costly due to the premium paid for the options. Delta hedging, in contrast, involves adjusting an existing options position.

• Adaptability: Delta hedging can be adjusted more frequently and precisely, whereas portfolio insurance strategies often involve periodic or formulaic adjustments.