The Performance of a Stock Index Futures Based Portfolio Insurance Scheme: Australian Evidence

In a Black Scholes world there exists a dynamic trading strategy that can replicate the payoff of an option. The technique of Portfolio Insurance is an application of this principle. This paper examines the ability of a futures based trading strategy to replicate the returns of a protective put option, thereby creating perfect portfolio insurance. The performance of these insured portfolios is simulated over a period from April 1984 to march 1989. Results indicate that portfolio insurance is effective at eliminating downside risk when the market falls significantly albeit at a level below the guaranteed minimum return. For smaller downward movements the results are not as encouraging. While the dynamic strategy may be able to "meet-the-floor" in cost adjusted terms, in most instances the terminal value of the insured portfolio is actually lower than the value of the market portfolio. Reducing the minimum required rate of return increases the likelihood of portfolio insurance being able to acieve its objective. Increasing the volatility estimate above the historical level - which is a way of incorporating market imperfections like transaction costs and futures mispricing into the model - resulted in better performance when the market fell but exacted a higher opportunity costs when prices were rising. Evidence suggests that market initiated rebalance strategies result in better performance although there is a clear transaction cost - replication error trade-off.