Risk Management And Derivatives Finance Essay - Free Essay Example

Dynamic asset allocation strategies are used by investors to hedge and insure their portfolio and thus, reduce their risk exposure. Each change in the value of assets in the portfolio will require from the investors to rebalance the asset allocation in order to keep the risk exposure constant. (Perold and Sharpe, 1995) In the European market, buying a put that we will exercise in order to make up for any decrease in the portfolio value is the most common method to hedge a portfolio. However, as European options are not available on listed exchanges in the U.S, investors have to find another way to insure their investments. A popular way to do so is to follow a dynamic asset allocation strategy. The most common one are: Buy-and-Hold strategies, Constant-Mix strategies, Constant-proportion portfolio insurance and Option-based portfolio insurance. Though, other authors identify different strategies that are not considered as being dynamic strategies. For example: the M omentum strategies (Miccolis Goodman, 2012) or Stop-loss order strategies (Rubinstein, 1985). In an attempt to have a better understanding of these strategies and to be able to discuss them, the first part of this essay will be focused on the presentation of these strategies, showing their differences and similarities, while the second part will discuss the different factors that have to be taking into account when an investor choices a strategy. Different strategies to insure a portfolio When investing in US listed exchanges, investors cannot use protective put to insure their portfolio and then, they have to employ others techniques that are expected to give the same level of insurance than the traditional method. In their paper, Perold and Sharpe (1995) present and explain the main dynamic strategies that can be use on the US market. Buy-and-Hold strategy is a Do Nothing strategy because after the purchase of an initial mix of bonds and shares, this mix is held and d oes not required any rebalancing, even in the case of a change in the relative values of assets. Conversely, Constant-mix strategies are do something strategies because when the relative values change, the investor has to rebalance the portfolio in order to keep the desired mix constant. This strategy buy stocks as they fall and sell stocks as they rise. On the other hand, while constant mix strategies buy stocks as they fall, Constant-proportion portfolio insurance (CPPI) sells stocks as they fall and buys stocks as they rise. The main characteristic of this strategy is to keep the exposure to equities a constant multiple of the cushion (i.e. Asset- Floor). By maintaining this risk exposure constant, CPPI has a very limited downside risk (Cont Rama, 2009). Like CPPI strategy, Option-based portfolio insurance (OBPI) strategies sell stock as they fall and buy stocks as they rise. OBPI is also characterized by the realization of the same payoff at horizon as a portfolio comp osed of bills and call options would do. These dynamic strategies are opposed to other strategies that can insure portfolio too. Miccolis Goodman (2012) present an example of Dynamic Asset Allocation: Momentum-based moving average (MA) strategies could aid to reduce the risk exposure of a portfolio and thus to achieve the goals of rebalancing. They identify different approaches insight these strategies. The first one involves the comparison of the MA value with the index; when the index is above the MA, the investor stays invested in the index; if the index is below the MA, he gets out. The second one is the Moving-Average-Crossover (MAC) strategy in which the investor uses two MAs (Short-term and Long-term) and when the short-term MA is greater than the long-term MA, he invests in assets. Unlike the first two approaches, the last one looks at the trend in the MA. When it is increasing, he has to invest in the asset, otherwise, he does not. In his paper, Rubinstein (1985) opposes dynamic strategies to Stop-loss orders that are one of the simplest techniques to insured a portfolio. The probability of experiencing any losses is zero and the investor does not need to look after the stocks performance every day. However, the market price can be different from the stop price as the value of the portfolio is not completely determined by the level of the SP 50 and then the insurance is not complete. Furthermore, in order to have a perfect portfolio insurance, Stop-loss order need to have a path-dependence equal to zero. Which one is the best? While comparing these different strategies, it appears that the choice of a specific strategy will depend of the degree of fit between a strategys exposure diagram and the investors risk tolerance. (Perold Sharpe, 1995) The type of market can also influence the choice of a strategy and the above strategies do not behave the same way in a volatile and not-so-volatile market. Volatile market and thus reversals will favor strategy that buys stocks as they fall and sells them as they rise (i.e. Constant-mix strategies) because the marginal decision will be good one as investors trade in a way that take advantage of the reversals. Conversely, the CPPI will perform well in a bull market because as its buying stocks as they rise, each marginal purchase will pay off substantially. A Buy-and-Hold strategy will perform well in a flat market while both CPPI and OBPI will poorly perform. Finally, investors are likely to prefer Constant-mix strategies to Buy-and-Hold strategies when the market ends up near its starting point and vice-versa (Perold Sharpe, 1995). When comparing CPPI with the OBPI, Bertrand Prigent (2002) found that there was no dominance between these two strategies when taking the mean-variance approach. They also found that CPPI are simple and flexible strategies to insure a portfolio because all the features can be chosen according to the own investors objective (i.e. Initial cushion, floor and multiple) and that OBPI can be considered as a generalized CPPI strategy. Miccolis Goodman (2012) compare the performance of the Momentum-based moving average (MA) strategies to the Buy-and-Hold one. They found that each of these strategies has different strengths and weaknesses, but no one was perfect. In order to call off these weaknesses, they prove that an investor may possibly use several momentum strategies that could be apply under specific market condition in which they perform well. A test has been realized and the results showed that this use of several momentum strategies at a different time period following the market condition perform similarly to a Buy-and-Hold strategy. However, Miccolis Goodman (2012) also remind that MA does not replace asset allocation and rebalancing but could be useful tool to provide in and out signals in order to improve the performance of a dynamic strategy. The need for resetting the characteristics of a strategy c ould also influence the choice of the investor. For example, while for the most of the dynamic strategies the resetting is not mandatory and depends on the investors aim, the OBPI has to reset these parameters at horizon. These strategies can be implemented in perpetuity but if the investors want to reset the parameters it can modify their basic characteristics and a CPPI strategy can easily become a constant-mix strategy by keeping a constant fraction of assets into the CPPI formula. Finally, investors with long time horizons usually prefer strategies that can be implemented in perpetuity (i.e. CPPI, buy-and-hold and constant-mix approaches) (Perold and Sharpe, 1995). Rubinstein (1985) states that when investors are looking to replicate a protective put, they are likely to favor other dynamic strategies than the Stop-loss order because they insure almost perfectly the portfolio while the Stop-loss order strategies suffer from extreme path-dependence. Finally, the choice of a strategy will depend of the investors preferences and of the market conditions. Conclusion When investors want to insure their portfolio in order to reduce their risk exposure, different options can be chosen. Stop-loss orders are one of the simplest techniques to insured a portfolio but the investors could also choice to apply one of the traditional dynamic asset allocation strategy: Buy-and-Hold strategies, Constant-Mix strategies, Constant-proportion portfolio insurance and Option-based portfolio insurance. It is not possible to say that one strategy is best for an investor and his choice will depend of his risk profile and of the market characteristics. However, Perold and Sharpe (1995) argue that the only strategy that all investors can apply is the Buy-and-Hold strategy because of its simplicity. An investor that has zero tolerance for risk is likely to apply a Buy-and-Hold strategy or a CPPI strategy while the tolerance for risk with an OBPI strategy will vary accord ing to the investors wealth. Moreover, these strategies do not perform the same way under different market conditions and an investor has to take into account these differences if he wants to have an efficient strategy. The choice of a strategy will then depend of how much risk and/or reward an investor is willing to bear.