Equilibrium Analysis of Portfolio Insurance

Sanford Grossman and Zhongquan Zhou

Journal of Finance, 1996, vol. 51, issue 4, 1379-1403

Abstract: A martingale approach is used to characterize general equilibrium in the presence of portfolio insurance. Insurers sell to noninsurers in bad states and general equilibrium requires that the risk premium rises to induce noninsurers to increase their holdings. The authors show that portfolio insurance increases price volatility, causes mean reversion in asset returns, raises the Sharpe ratio and volatility in bad states, and causes volatility to be correlated with volume. They also explain why out-of-the-money S&P 500 put options trade at a higher volatility than do in-the-money puts. Copyright 1996 by American Finance Association.

Date: 1996
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