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1 May 1984 Financial Analysts Journal Volume 40, Issue 3

Risk-Return Tradeoffs of Contingent Insurance Strategies for Active Bond Portfolios

  1. Robert B. Platt
  2. Gary D. Latainer

Portfolio insurance is a generalized procedure for controlling bond portfolio risk by using asset allocations to replicate option strategies. A manager can purchase different levels of downside protection, or insurance, by allocating varying proportions of his portfolio’s wealth over the holding period between an immunized, or riskless, pool and an active, or risky, pool. The cost of achieving a given level of insurance, in terms of the potential return from active management that must be given up, is related to the proportion of the portfolio that can remain in the risky pool at the initiation of an insurance procedure and still meet the minimal return benchmark.

The portfolio insurance concept can readily be incorporated into a decision framework for analyzing the percentage of expected return from active management that must be given up in order to obtain a given level of insurance. The optimal tradeoff will depend on the probabilities the manager assigns to being correct or incorrect in his interest rate expectation. Inasmuch as most managers are unlikely to assign a 100 per cent probability to either outcome, most managers should not be either fully immunized or fully active; they would be better off following a portfolio insurance strategy.

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