Friday, December 24, 2010

Portfolio Insurance

Portfolio insurance is the use of derivatives to limit, reduce, or eliminate downside risk. Portfolio insurance can be achieved through a number of manners, but the most common are to either sell index futures, or buy protective put options. Using index futures will eliminate or limit downside, but will also remove upside gains. Using options will limit downside risk but retain upside exposure, however there is a cost involved i.e. option premiums - which tend to increase during times of high volatility. Portfolio insurance needs to be implemented by the investor themselves, but fund managers may implement it for large clients, for smaller clients a qualified financial advisor should be able to assist. Investors may use this practice of portfolio insurance when the market direction is particularly uncertain or volatile, or even if there is a period of time where it is unpalatable for the investor to see capital depreciation (e.g. due to life events).

Synonyms: Protective puts, Shorting futures, Cap downside, Synthetic options, Financial risk management, Hedging

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