Portfolio insurance


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Portfolio insurance

  2. 2. INTRODUCTION  No one can predict exactly what will going to happen tomorrow, so everyone wants to secure there tomorrow. For the purpose of securing our tomorrow we will go for insurance. we are all very much familiar with insurance concept and most of us entered and entering into the insurance agreement like Life insurance, Health Insurance, Vehicle Insurance and Wealth Insurance but our investments (Portfolio &Mutual Fund) are not covered by insurance because most of us do not aware of Portfolio Insurance.
  3. 3.  Everyone insuring to protect their future. We are all making investment for the future benefit but our investment will affect by volatility in the market other reason, it’s called as total risk. Due to this market risk volatility the investor may unable to get his desired or expected return in future. So, it’s essential to protect our investment by covering it by insurance
  4. 4. MEANING Portfolio insurance is an investment strategy where various financial instruments like equities and debts and derivatives are combined in such a way that degradation of portfolio value is protected  Portfolio insurance is a method of hedging a portfolio of stocks against the market risk by short selling stock index futures 
  5. 5. EVOLUTION OF PORTFOLIO INSURANCE  Introduced by Hayne E. Leland and Mark Rubinstein (11th September 1976) The market crash of 1973-74 may intended the investor start withdrawn their fund from stock market. Haney E. Leland understood this situation and appeals the new financial product called portfolio insurance. He suggested put option as tool (Option Based Portfolio Insurance ).
  6. 6.  In 1987 Black and Jones proposed the new Portfolio Insurance strategy using the risky (equity) and riskless (bonds) assets in portfolio. this strategy is known as Constant Proportionate Portfolio insurance(CPPI)
  7. 7. Effect of portfolio insurance
  8. 8. HOW THE PORTFOLIO INSURANCE WILL WORK? There are two types of portfolio insurance strategy : 1) Option Based Portfolio Insurance(OBPI) 2)Constant Proportionate Portfolio Insurance (CPPI)
  9. 9. Option Based Portfolio Insurance(OBPI)  OBPI is achieved by using financial derivatives like put option. In this strategy when market is seems to decrease the investor hedge his portfolio of stocks against the market risk using put option on stock index futures. Advantages: 1) faster execution 2) greatly reduced transaction costs
  10. 10. How OBPI works first select an index with a high correlation( negetive ) to the portfolio we wish to protect.  Then calculate how many contracts to buy to fully protect the portfolio using the following formula. No. Index Puts Required = Value of portfolio / (Index Level x Contract Multiplier) 
  11. 11.  A fund manager oversees a well diversified portfolio consisting of thirty large cap. stocks with a combined value of 10,000,000. Worried by news about a possible outbreak of war in the middle east, the fund manager decides to insure his holding by purchasing slightly out-of-the-money S&P 500 index put expiring in two months' time in December. The current level of the S&P 500is 1500 and the DEC 1475 SPX put contract costs 20 each. The SPX options has a contract multiplier of 100.
  12. 12.  So the number of contracts needed to fully protect his holding is: Value of portfolio / (Index Level x Contract Multiplier) 10000000/1500 x 100 = 66.67 or 67 contracts. Total cost of the options is: 67 x 20 x 100 = 134,000
  13. 13. Index Portfolio Value Put Option Value Insured Portfolio 1200 8,000,000 1,708,500 9,7085,00 1300 8,666,666 1,038,500 9,705,166 1400 9,333,333 368,500 9,701,833 1500 10,000,000 -134,000 9,866,000 1600 10,666,666 -134,000 10,532,666 1700 11,333,333 -134,000 11,199,333
  14. 14. Effects of portfolio insurance:  When market falls  When market rises  When market is flat .
  15. 15. CPPI (Constant proportion portfolio insurance) CPPI strategy is about proportionate of risky (equity) and riskless (bonds) assets in a portfolio to avoid the risk protect the value of portfolio. CPPI is a method of portfolio insurance in which the investor sets a floor value of his or her portfolio and then structures asset allocation around that decision. The two asset classes used in CPPI are a risky asset (equities or mutual funds), and a riskless asset of cash, equivalents or Treasury bonds. The percentage allocated to each depends on the "cushion" value.
  16. 16. Advantages of cppi : Does not require derivatives  Fewer management expenses  Adjustable risk and reward 
  17. 17. Attributes      Generally, portfolio insurance can be thought of as holding two portfolios. Risky and riskless assets The floor level, the lowest value the portfolio can have, is viewed as the safe or riskless portfolio with value equal to the level of protection desired. The second portfolio is portfolio cushion which consists of the difference between the total value of the portfolio and the floor. These assets consist of a leveraged position in risky assets. To insure the portfolio, the cushion should be managed so as to never fall below zero in value because of the limited-liability property of common stock.
  18. 18.  Portfolio value: It is the total financial value of the portfolio as on the day.  Floor value It is the minimum value can be realized by the portfolio as on that day. It’s normally calculated using time value. In this case riskless assets return will be the discount factor Value of portfolio should not goBelow the floor value .. Cushion value It is a difference between portfolio value and Floor value. (portfolio value- Floor value). Its also called as Gap value. It will help to determine the investment value of Risky assets.  Cushion = portfolio value – floor value
  19. 19.  Multiplier Multiplier= exposure /cushion Exposure = value of risk free assets
  20. 20. Value of multiplier   
  21. 21. Determining proportion Risky assets= multiplier * cushion value Riskless assets= total portfolio value – risky assets m e c 500 200 2.5
  22. 22. Empirical example
  23. 23. Maxloss –20 % Multiplier = 5 Translated into hedging system Risk-free Bonds 50 Euro Equities 75 Euro Protection Level 90 Euro Risikofreie Renten 30 Euro 105 Euro 105 Euro Maxloss –20 % Multiplier = 5 Equity market rises by 10 % Equities 55 Euro 105 Euro Cushion 15 Euro Cushion 10 Euro Maxloss –20 % Multiplier = 5 Equities 45 Euro Risk-free Bonds 50 Euro Translated into hedging system Protection Level 90 Euro Equities 25 Euro Risk-free Bonds 70 Euro 95 Euro Equity market falls by 10 % Cushion 5 Euro 95 Euro Risk-free Bonds 50 Euro 95 Euro Protection Level 90 Euro 100 Euro 100 Euro Equities 50 Euro
  24. 24. CONCLUSION The portfolio insurance is much needed for investor. These insurance technique help to reduce the unexpected future loss some time it avoids the loss also but it incur some cost (in case of OBPI) or it will slowdown (in case of CPPI) but it will not affect the investors investment because these techniques are came to exist to protect the investor investments.  The OBPI will helpful in case of aggressive portfolio when market volatile affect it. This can be useful for blue chip portfolio and mutual funds.  The CPPI is good for all the situation and for all type of investment because it will reduce the risk by investing in riskless assets. 
  25. 25. Investors who have average expectations, but whose risk tolerance increases with wealth more rapidly than average, will wish to obtain portfolio insurance.  Investors who have average risk tolerance, But whose expectationsof returns are more optimistic than average will wish to obtain portfolio insurance. 
  26. 26. THANK YOU…