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Behavioral portfolio insurance strategies

Marcos Escobar-Anel (), Andreas Lichtenstern and Rudi Zagst
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Marcos Escobar-Anel: The University of Western Ontario
Andreas Lichtenstern: Technical University of Munich
Rudi Zagst: Technical University of Munich

Authors registered in the RePEc Author Service: Marcos Escobar Anel ()

Financial Markets and Portfolio Management, 2020, vol. 34, issue 4, No 1, 353-399

Abstract: Abstract Portfolio insurance strategies that ensure a certain minimum portfolio value or floor such as the Constant Proportion Portfolio Insurance (CPPI) and the Option-based Portfolio Insurance are economically important and widely spread among the banking and insurance industries. In distress and volatile market environments, investors such as pension funds have a need to insure their portfolios against downside risk in order to meet certain future payments or liabilities. Non-anticipated shocks or negative interest rates, jumps, crashes, or overnight trading restrictions in stock prices could drop pension fund portfolios below desired levels (present value of pension obligations) making them underfunded with pension assets to pension liabilities ratio below 100%. In particular, within the current low interest rate environment, a high number of pension funds happen to be underfunded which is a severe practical problem. Because of such scenarios, there is a need for an investment strategy which covers both the case of funded and underfunded portfolios. This article introduces a novel strategy which generalizes the CPPI approach. It has the overall target of guaranteeing the investment goal or floor while participating in the performance of the assets and limiting the downside risk of the portfolio at the same time. We show that the strategy accounts for behavioral aspects of the investor such as distorted probabilities, a risk-averse behavior for gains, and a risk-seeking behavior for losses. The proposed strategy turns out to be optimal within the Cumulative Prospect Theory framework by Tversky and Kahneman (J Risk Uncertain 5(4):297–323, 1992).

Keywords: Portfolio insurance; Portfolio choice; Pension funds; Behavioral finance; S-shaped utility function; Probability distortion (search for similar items in EconPapers)
JEL-codes: C61 G11 G41 (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1007/s11408-020-00353-5

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