What is Portfolio Insurance?
Portfolio insurance is a strategy of hedging a portfolio against market risk by short selling stock index futures. A portfolio is a range of investments held by a person or organization.
It is a technique often employed by institutional investors when the market shows signs of volatility.
Using this strategy offsets any downturns, however, it also sets back any gains.
This technique was invented in 1976 by Hayne Leland and Mark Rubinstein, two young finance professors at Berkeley. It is actually frequently linked with the stock market crash of October 19th, 1987. It was a risk management weapon created during fierce market decline. However, when tested it rapidly revealed a critical flaw.
According to the École Polytechnique CNRS, a portfolio insurance strategy:
- Maintains the portfolio value above a predetermined level while allowing for some upside potential.
- Measures performance compared to a market index or can be guaranteed in terms of this index.
- Is typically set up with a strategic allocation between the benchmark index, risk-free account and option on the benchmark index.
- Option-based portfolio insurance (OBPI).
- OBPI with option replication.
- Constant proportion portfolio insurance (CPPI).
Several factors contribute towards market risk, including stock market fluctuations, commodity prices, inflation, political unrest, natural disasters, and trade embargoes.