Portfolio Insurance
Categories: Insurance
See: Portfolio. See: Hedge Ratio.
When you "buy portfolio insurance," you are spending money to buy put or call options, something like 5-20% away from current portfolio prices, so that, should the best laid plans of mice and men go awry, you will have netting in the form of derivative hedges to cushion your fall.
If portfolio insurance were free, everyone would do it always. But it ain't. In fact, portfolio insurance pricing varies massively, usually in lockstep with the VIX. Not the Vapo-Rub.
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Finance: What is a hedge ratio?6 Views
and finance Allah shmoop What is a hedge ratio Okay
people of future hedge fund managers it's the ratio or
per cent of the total that you're hedging total portfolio
that you're hedging or protecting in you know in a
bad market So let's go through the market numbers here
that we're goingto totally and completely make up But they're
reflective of reality anyway And most reality we're going to
start with the notion that our entire portfolio at the
moment is one security ticker S p y Which more
last represents the S and P 500 That ticker trade
Today it's about 300 bucks a unit We're running a
hedge fund a lucrative one and our investors expect us
to protect their investments in both good and bad markets
So the question How much are we willing to pay
Hey for that portfolio life insurance How far down are
we okay letting this $300 per unit index fund fall
before we hedge it or protected Well pricing matters right
So if we want to protect it for three months
such that even $1 below $300 that are hedges kicked
in Well it'll cost a fortune something like $20 a
share maybe more That's a huge premium to pay for
protection which if the index unit stays flat at $300
for the next three months and change or even goes
up well we've lost 20 divided by 300 there or
about 7% of our portfolios Value way expensive What if
we were okay with it falling to 2 80 but
then protecting it below 2 80 meaning the strike price
of our puts will be a 2 80 right Well
the pricing there is to buy those put options with
a strike of 2 80 which expire in three ish
months Not a cost Eight bucks a share Yes we're
making up the numbers It's still expensive but well maybe
that's digestible aid over three hundred's about two and 1/2
percent change It's that worth it well for you and
realize that that's 10% a year and edges out Maybe
maybe depends how nervous we are what our position is
on where the markets heading the next 90 Well if
we look at the 2 60 strikes well then they
only cost $2 a unit toe fully hedged 100% of
our portfolio then it's less than 1% Maybe we do
that right We're going bye puts the 2 60 strikes
of the market would have to go down well over
10% in the next 90 days to kick those in
And that would be a lot right So we're vastly
generalizing the numbers here in order to present clarity or
conceptual clarity for you people as it relates the notion
of a hedge ratio The bigger question revolves around that
100% figure that is Do we really need to hedge
Ah 100% of our portfolio What if we were okay
with well 20% of it being 100% exposed to the
market totally floating or that 20% of the portfolio is
ah 0% hedged If we're paying $20 a unit to
hedge a $300 strike prices well then only 80% gets
Ah may be a tad more digestible Or what if
we only cared about hedging 50% of the portfolio so
that half is floating and half his head Maybe the
bookie that we're going against is the S and P
500 itself And if it went down 20% we were
only down 10 Maybe our investors would heart us What
do you think Well there's a whole bunch of math
behind these numbers and obviously none of it exists in
a vacuum without logic behind it But it's this percent
of portfolio thing here that we care about in a
hedge ratio because that is the notion of a hedge
ratio How much of our investment universe do we want
to pay to protect And how much are we willing
to pay for that protection And it's always the right
answer Yeah cue the adult diaper company It depends right
Well on what Well on how nervous Nellie our investors
are like how much do we really care about the
volatility of our portfolio Like here's the S and P
500 a chart of it for the last century and
change And yes it went up a lot but naked
it was hugely volatile Do we really care if all
we looked at was the price here and then the
price here it went up a ton While protecting the
volatility was just a waste of money then like buying
a month of term life insurance is a waste in
a month when you don't die So if we don't
care about the volatility then maybe the hedge ratio oughta
be zero or nothing Like why would we buy a
hedge fund at all if we don't care Overtime hedging
is a bad bet in markets that generally go up
And over time the market is up Something like six
out of seven years Right So when you hedge things
you're betting things were going awry here So do you
really want to bet against that system and hedge portfolios
Bet against capitalism Maybe bet against America Yeah probably not
So the next question the next it depends Question Well
how much do the hedges cost That is if you
could buy $1,000,000 term life insurance policy for 10 bucks
a month And even if you had nobody on Earth
you really cared about leaving the money too But maybe
if you got whacked by the 2 30 mid 10
bus what then You'd want to leave a profess Auriol
chair to your all the mater with that 1,000,000 box
and then maybe you'd spend the 10 bucks a month
on while that term life insurance head right But if
it was a few grand a month well then maybe
you're not going to pay life insurance company All that
money maybe you'll just invested instead on your own So
hedge ratios kind of live in the land of it
depends whether you want them at all or what percentage
of your portfolio you want to protect And how much
that portfolio life insurance actually costs like the other depends
It's all about protecting yourself from unforeseen accidents not get