What is Portfolio Insurance?
Portfolio Insurance is the term assigned to the practise of limiting the losses or even eliminating the losses, for a position which you take in stocks or bonds or in any other set of investments. It is a method of hedging a portfolio of stocks against the market risk by short selling stock index futures.
How is Portfolio Insurance achieved?
Portfolio Insurance is achieved by using Financial Derivatives or Options. So Basically, you buy a stock, as long as it is above its buy price, you are in profit. The risk or loss comes when the price of the stock goes below your buy price. Hence, the practise of eliminating this loss is known as Portfolio Insurance. Some financial experts also claim that risk can never be eliminated from a Portfolio, only its effects can be mitigated. Hence, the practise of mitigating the risks from the Portfolio is known as Portfolio Insurance.
What is the commonly believed rationale behind Portfolio Insurance?
Portfolio Insurance: The Rationale behind Portfolio Insurance
Let's say you have the following 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:
..You can Expect that FED will tighten the rates in next three months
..You have a constraint that your Portfolio value should not go down below $90,000
.. What's the solution?
.. Go for Portfolio Insurance, by structuring options products in your portfolio
What will be the cost of this portfolio insurance?
Let's say: Cost of 3m put option which has a $45 strike price is $0.79
..So we Need 2,000 options
..Hence the total cost of this portfolio insurance comes to $0.79 times 2000 = $1,586.00 USD
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