Portfolio Insurance

Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority and you can order it here)

A form of hedging that uses STOCK INDEX FUTURES contracts and index options to limit the downside risk of holding a diversified portfolio of common stocks.  PI programs are offered by major banks, brokerage firms, insurance companies, and other financial institutions.  They have attracted many large institutional holders of common stocks like pension funds and mutual funds.

When the stock market declines, holders of common stocks traditionally begin to move some portion of their assets out of stocks and into cash to protect themselves against further declines in the market.  PI programs attempt to hedge against the possibility of a market decline by selling stock index futures contracts or stock index options (buying stock index put options).  The more the market falls, the more futures and options contracts are sold by PI programs.  If the market continues to fall, the rise in the value of the portfolio’s futures and options positions cushions the decline in the value of the portfolio’s common stocks.  PI managers believe that such HEDGING programs using futures and options involve lower transaction costs and provide greater liquidity than the traditional method of actually selling stocks and buying Treasury bills.

Portfolio insurance differs from true insurance in that it does not guarantee protection in the event of a market downturn.  In the market crash of October 19, 1987 , many PI programs had to be shut down because trading in financial futures and options was suspended.  As a result, many portfolio managers were surprised to find that their PI programs provided little or no protection.  Many PI programs were discontinued after the crash because the increased market volatility raised the cost of PI programs to unacceptable levels by increasing the implicit cost of futures and options premiums.  PI programs also have been blamed for exacerbating the market’s turmoil during and following the 1987 crash.  

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