Portfolio Insurance (1)

# Portfolio Insurance (1) - Portfolio Insurance Copyright...

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Copyright © 1998-2006 Investment Analytics Portfolio Insurance Slide: 2 Portfolio Insurance ± What is it? ± Why use it? ± How to apply in practice
Copyright © 1998-2006 Investment Analytics Portfolio Insurance Slide: 3 Portfolio Insurance: Rationale ± Portfolio ± 1000 shares stocks A, 1000 shares stock B ± Volatility of each stock 30% ± Current stocks price of A and B is \$50 ± T-Bill rate is 8% ± Scenario: ± Expect FED to tighten in next three months ± Portfolio value must not fall below \$90,000 ± Calculate all-in costs of protection: ± Use the option calculator ± Worksheet: Portfolio Insurance Intro

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Copyright © 1998-2006 Investment Analytics Portfolio Insurance Slide: 4 Cost of Protection ± Cost of 3m put option with \$45 strike is \$0.79 ± Need 2,000 options ± Hence all-in cost is \$0.79 x 2000 = \$1,586
Copyright © 1998-2006 Investment Analytics Portfolio Insurance Slide: 5 Hedging a Portfolio ± Next, assume A and B are uncorrelated: Corr(A,B) = 0 ± Compute the volatility of the portfolio ± Calculate the all-in cost of hedging the portfolio ± Reminder: σσ σ ρ p ww w w =+ + [] 1 2 1 2 2 2 2 2 12 2

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Copyright © 1998-2006 Investment Analytics Portfolio Insurance Slide: 6 Cost of Hedging Portfolio ± Hedging Cost: ± SD of Portfolio 21.21% ± Black Scholes option price \$0.29 ± Hence cost of portfolio hedge: 2,000 x \$0.29 = \$579 ± Cost saving = \$1,007 ± Finding: Cost of option on portfolio is less than cost of portfolio of options
Copyright © 1998-2006 Investment Analytics Portfolio Insurance Slide: 7 Evolution of Portfolio Insurance ± PROBLEM: option on portfolio doesn’t exist ± Hence create put option synthetically ± Replicate hedged portfolio ± Dynamic Hedging Strategy ± Leyland, O’Brien, Rubenstein (LOR)- 1980’s

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Copyright © 1998-2006 Investment Analytics Portfolio Insurance Slide: 8 Portfolio Insurance Illustrated Fund Value S&P500 Insured Portfolio Floor
Copyright © 1998-2006 Investment Analytics Portfolio Insurance Slide: 9 Portfolio Insurance Illustrated Fund Value S&P500 Insured Portfolio Cost Deductible Floor

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Copyright © 1998-2006 Investment Analytics Portfolio Insurance Slide: 10 Insurance S&P500 Insured Portfolio Cost Smaller Deductible = Higher Cost Deductible Fund Value
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## This document was uploaded on 11/04/2011 for the course ECON 421 at CUNY York.

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Portfolio Insurance (1) - Portfolio Insurance Copyright...

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