Asset Dependency Structures and Portfolio Insurance Strategies

Abstract

The estimation of the multiplier parameter of portfolio insurance strategies is crucial for its implementation because it determines the risk exposure to the performance-seeking asset (PSA) at each point in time. Studies that address the estimation of the multiplier’s upper bound have been limited to strategies that use as the safe asset a short-term bank account, in which case the co-movements of the safe and the PSA become irrelevant. However, in several relevant applications, portfolio insurance strategies use stochastic reference assets different from cash, such as the control of active-risk relative to a benchmark, or insuring a minimum level of retirement income. We find that the implications of taking into account the assets’ co-movements in the multiplier estimation can be crucial. In Monte Carlo simulations the multiplier doubles in size across scenarios, and the strategy using the proposed approach presents stochastic dominance over the strategy that ignores the asset dependency structure.