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Reducing market exposure with portfolio insurance.

Potkin A. Basseer, Ph.D., formerly a professor of finance at The College of insurance in New York, is a consultant to the financial industry.

A significant portion of insurers' assets are invested in market-sensitive financial instruments such as stocks, high- and low-grade corporate bonds and mortgage securities. As a result, risk managers must not only deal with pure risk in their firms, but they must also be knowledgeable regarding the impact of market risk on the value of their insurers' assets.

The decline in value of unhedged market-sensitive assets erodes insurers' capital, diminishes their ability to remain solvent and may increase future premiums for insured firms. The exposures of insurers with portfolios of market-sensitive securities, including The Pacific Standard Life Insurance Co., which, with $7 billion of insurance, was declared insolvent by the California Department of Insurance last year, has raised doubts regarding the financial condition of many insurers.

Furthermore, risk managers today are more involved with the risk assessment of the firm's employee pension investments, which are often placed with insurers and pension management firms. For example, approximately 65 percent of the nation's 401(k) pension plans, amounting to more than $150 billion, is invested in guaranteed investment contracts. Since the "guarantee" in these contracts often relates solely to the full faith and credit of the insurer issuing the contract, the impact of market risk on the assets of the guarantor becomes a key factor in assessing the contract's safety. In addition, a decline in the market value of the firm's own securities portfolio can influence a risk manager's risk financing and risk control alternatives, since it affects the internal availability of funds.

Although the recent decline in the value of the portfolios of some insurers and other financial institutions, such as thrift institutions, has been alarming, many of the more reputable ones have long used different portfolio insurance (PI) mechanisms to hedge risky assets against market risk. Therefore, knowing how PI works and to what extent it is used has become an important aspect of a risk manager's job. In addition, paying close attention to PI gives greater insight into the link between asset and liability management of most financial institutions, particularly insurers.

The Need for PI

The theory of flawed systems analysis, in the context of risk management, holds that unplanned events are operational errors rather than mishaps. In systematic portfolio management the greatest operational error is being unprepared for market risk. The reason for acquiring PI arises from the basic tenets of modern portfolio theory, which hold that although increasing diversification of holding equities reduces and ultimately eliminates company-specific or unsystematic risk, it does not reduce the exposure to the market or systematic risk.

The unsystematic risks associated with such mishaps as lawsuits, strikes, successful and unsuccessful takeovers, poor marketing plans and bad management in a single firm can be eliminated through diversification. Mishaps in one firm can be offset with good fortune in another. Market risk, on the other hand, stems from factors that simultaneously affect all firms, such as inflation, rising interest rates, recession and war. For instance, during the 1987 stock market crash, more than 95 percent of the stocks listed on the New York Stock Exchange declined in value, followed by stock market crashes around the globe. The aim of PI is to provide protection against a portfolio's downside risk while preserving the potential for upside gains.

Most financial institutions are required to hold diversified portfolios to reduce or eliminate unsystematic risk. However, since many of their assets consist of equities, the need for hedging against stock market downturns becomes self-evident. Regarding the assets of different types of financial institutions, corporate stocks comprise approximately 50 percent of private pension fund assets, 50 percent of mutual fund assets, 19 percent of property/casualty insurers and 10 percent of life insurers. In addition, private placements, high- and low-grade and convertible corporate bonds, mortgage securities, commercial real estate and other investments with a high exposure to systematic risk make the use of PI more evident.

In fact, under Financial Accounting Standards 87, the change in the market value of a financial institution's assets relative to its liabilities can severely affect reported earnings. PI can prevent the value of a financial institution's assets from falling below the market value of its liabilities. Also, keep in mind that the need for PI is not unique to large financial institutions with diversified stock holdings. Individuals and non-financial corporations holding equities, shares of unhedged mutual funds and equity-based pension plans and other market-sensitive investments can also benefit from Pl.

Although the precise value of portfolios using different types of PI is unavailable, an estimated $60 billion to $90 billion of institutional funds were covered by PI as of September 1987. While some PI schemes using dynamic hedging techniques that require continuous trading did not work well during the 1987 crash, other plans, particularly those using static PI policies, worked relatively well and saved risk-averse investors billions of dollars in potential losses. By mid-1988, the use of dynamic PI plans dropped by as much as two-thirds. Since then, with the resurgence of the stock market, the use of PI has increased although at a slower pace.

The insurance industry in the 1980s, despite being a big user of PI, has been conspicuously absent from offering PI to its own clients. Since insurers specialize in combining different classes of risk, thus offering protection at a low cost, they are best able to offer PI at competitive prices. Furthermore, long-term, static protective options could take pressure off stock and futures markets, resulting in a more orderly equities market. By introducing a more flexible, attractive mutual fund insurance, the industry could re-enter the vast market for Pl.

Listed Index Options

The basic tool of PI is a put option on stock market indexes, such as Standard & Poor's, the New York Stock Exchange and Major Market indexes. The put option gives the purchaser the right to sell the respective index at a predetermined price within a given time period. The predetermined price, or strike price, is similar to the maximum protection in excess of a deductible in a conventional insurance policy. The given time to expiration is similar to the term of an insurance policy.

If by the expiration date of the put option contract, the underlying index falls below the strike price, the put holder exercises his or her option at the strike price and collects the difference in cash. This benefit would compensate for the loss stemming from the decline in the portfolio's value due to the market downturn. Although the investment manager has received cash that could be reinvested, the original portfolio is intact and has not really been sold.

The put option is a flexible stop-loss PI plan, which, unlike ordinary stop-loss orders, lets investment managers retain their portfolios. With the protective put option, the market price of the put is similar to the premium on a traditional insurance policy. The put premium is highly dependent on the strike price, or the protection floor, similar to the premium of a conventional insurance policy.

However, unlike indemnity in an insurance policy, which prohibits the insured's profiting from an insurance contract, the put buyer can choose a strike price higher than the prevailing market level and lock into a profit. The profit would equal the difference between the prevailing market level and the strike price if the cash outlay for the option premium is ignored. However, the premium for put options is usually higher than the difference between the strike price and the prevailing market price of the underlying asset.

The investment manager can choose a strike price lower than the prevailing market level. The difference between the strike price and the index value of this type of put option is similar to the deductible in a conventional insurance policy. Just as in an insurance contract, the higher the deductible the lower the premium, because the put buyer is offered a lower protection floor. On the other hand, put options with a strike price higher than market level are generally more expensive, since they provide higher protection against market downturns.

In addition to strike prices, option prices are also dependent on expiration dates, the value of the underlying asset, the level of interest rates and the anticipated risk of the underlying asset. According to the Option Pricing Model, developed in 1973, the anticipated riskiness of the underlying asset can be measured by the standard deviation, which is a measure of the volatility, of the underlying asset. Although not foolproof, this and similar models help assess option prices prevailing in option markets.

Betas and Deltas

Until now it was assumed that the underlying portfolio was correlated with the market, represented by an index, such as Standard & Poor's 500. That is to say the portfolio's "beta," or measure of its sensitivity to market risk, was 1.00. In practice, the underlying portfolio may be comprised of securities that are more or less sensitive to market risk. For instance, if past performance shows that the beta of the portfolio was 0.5 (50 percent less sensitive to systematic risk than the market portfolio), then the investment manager may want to buy 50 percent less insurance. However, if the beta of the portfolio was 1.5, the manager may want to buy 50 percent more put options. The beta of different stocks is published by most advisory services. The beta of the portfolio is simply the weighted average of the betas of its component securities.

The need for buying more insurance also stems from the fact that the drop in the value of the index is not necessarily on a one-to-one basis with the risk in put prices. The sensitivity of option prices vis-a-vis the changes in the value of the underlying asset is called delta. Put options commonly have negative deltas, since their prices are inversely related to the prices of the underlying asset. Thus, assume that a particular put option has a delta of -0.5; then a 10 percent decrease in the price of the underlying index is expected to cause only a 5 percent increase in the price of the put. In this case, to be fully covered, the investment manager should buy twice as many Put options.

The deltas of different options are published weekly in Stock Option Guide and are also available from most full-service brokerage houses. Since deltas change frequently with the price of the underlying index, the investment manager must continuously adjust the number of options held to be fully covered at all times.

If the put purchaser wants to hold the option to their expiration date or roll them over infrequently, he or she is implementing a static PI plan. However, an investment manager who wishes to obtain PI on a continuous basis, to be covered with small movements of the market, is implementing a dynamic PI policy. For example, if the value of the market rises, the investor may want to buy more puts; if the market declines, the investor may want to sell some put options to compensate for the portfolio's loss.

Generally, the investment manager does not want to continuously trade options or other instruments merely to insure the value of the portfolio. If nothing else, the transaction costs of such a strategy would be prohibitively high for most investors. Static PI plans are more attractive to investors who tend to follow a buy and hold policy. To meet that feature, in late 1987 the Chicago Board Options Exchange listed long-term index options on the Standard & Poor's 500 Index that better serve the static implementation of Pl. These policies worked well during the 1987 crash, as long as the investment manager did not want to renew an insurance policy at that time. This was because option premiums climbed sharply around that period, reflecting the uncertainty and volatility of the market.

Dynamic Hedging

Because continuously purchasing put options has high transaction costs and requires initial injections of cash, implementing a dynamic PI plan using index options is usually expensive. Dynamic hedging techniques attempt to replicate put options by creating synthetic puts. The process calls for balancing the portfolio toward the risky assets if their value increases and rebalancing toward the risk-free asset if their value decreases. In practice, the investment manager buys more stocks as prices increase and sells them when prices decrease, placing the proceeds in Treasury securities to assure a target rate of return. Dynamic hedging has also been used for trading bonds, foreign currencies and other risky assets.

Dynamic hedging replicates a protective put option by continuously shifting between a portfolio of risky assets, such as stocks, and risk-free assets, such as Treasury bills. To create such a synthetic put, a short position in the risky assets must be created. A short position, which involves borrowing and selling securities for future replacement, becomes more valuable as the price of the risky asset falls. Although theoretically straightforward, implementing such a PI plan requires continuous monitoring and allocation of scarce management resources.

Dynamic PI

The problem with the original implementation of dynamic hedging is that the normal buy and sell decisions of the investment manager are constantly disrupted by the implementation of Pl. This problem is solved by substituting index futures, such as the Standard & Poor's 500 Index, for the short position in stocks. In this process the investor combines holding stocks with a short position in index futures on the same basket of stocks. If prices increase, the investor will hold more stocks; if prices decrease, the investor will increase the short position. The loss suffered in the portfolio from declining prices is compensated by the gain from the short position in the futures contract. The benefits of using futures are low transaction costs and minimal margin requirements.

However, all dynamic PI plans are designed to work only in orderly markets. During the 1987 crash, the volatility of stock prices, index futures and options in different exchanges made such strategies impractical. At that time futures were selling at a discount to cash stocks, and since the arbitrage line was broken between the two markets, dynamic portfolio insurers were adversely affected. That is why critics of dynamic hedging maintain that when disaster struck, portfolio insurance did not pay. The Brady Report, commissioned by President Reagan after the crash, also correctly alluded that dynamic PI plans contributed to the increased volatility of the market.

Because dynamic PI usually increases stock demand when prices increase and adds to sell orders when prices decrease, it accentuates price swings in either direction. However, if markets are orderly, the decline in prices attracts new buyers to the market, and when prices increase more sellers tend to make a profit, thus absorbing the effect of PI. But when panic strikes, as it did in 1987, there are not enough buyers to offset the avalanche of sell orders. That is why long-term static PI policies generally function more smoothly than dynamic ones, since they do not require continuous trading and adjustments to the portfolio.

The Cost of PI

The cost of implementing a PI plan can be measured on an ex-post basis by empirically observing the past returns of an uninsured portfolio, such as the Standard & Poor's 500 Index fund, and an insured one. Focusing on dynamic hedging, some investment management firms have concluded that in the long run the costs justify such PI plans. Some have concluded that it is possible to outperform the market by continuously implementing dynamic PI plans. However, actual and impartial results are not conclusive to date.

According to a separate study conducted by this writer, the static implementation of PI with index options is not costless. Using the highly liquid and popular options on the Standard & Poor's 100 Index as a hedging tool, the study found that although a static PI plan decreased a portfolio's risk by more than one-third, it had an opportunity cost. By constructing a systematic PI plan using quarterly put options with lower than market level strike prices, an investor would have sacrificed approximately one-third of the market's 16.5 percent annual rate of return from March 1983, when the Standard & Poor's 100 Index options were first introduced, through December 1989. Those figures confirm that in PI, as in other risk management strategies, there are no free rides.

In addition to opportunity costs associated with PI plans, one must add transaction costs, taxes, time and other managerial resources needed to administer a PI plan. The advantage of a self-administered plan lies in a competitive bidding process that sets a fair price on the PI plan, reflecting all perceived risks. However, that advantage turns into a disadvantage when panic strikes, escalating the cost of insurance. One remedy is to invest in hedged funds or to go with an institution, such as an insurer, that specializes in portfolio risk management.

With the market value of U.S. equities surpassing the $3.5 trillion mark and the value of foreign stocks being already higher than that, preservation of capital by all stockholders becomes imperative. PI offers risk-averse investors an opportunity to hedge against the downside market risk while preserving much of the upside potential. Although most major stock markets have witnessed a bull market since 1982, the potential for a bear market in the 1990s is certainly a possibility. Millions of individual investors, thousands of corporations and most insurers and pension funds are still vulnerable to market risk. However, with innovations in financial markets, market risk is becoming more manageable.
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Author:Basseer, Potkin A.
Publication:Risk Management
Date:Apr 1, 1991
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