Leland OBrien Rubinstein Associates Inc Portfolio Insurance Case Solution

The idea for this commercial venture came from the needs of the institutional investors for insurance against their portfolio, in order to protect against the downside risk of the portfolio while allowing for the upside and hence survive in worst market times. Previously, investors could measure the risk of their investment, but there was little they could do to remove the risk and investments were only made when worst case return was tolerable. The three available alternatives for investors to manage the risk of their investment are: diversification, hedging, or insurance. Portfolio diversification refers to the strategy of reducing risk by combining many different types of securities with correlation less than one. This strategy of diversification eliminates the idiosyncratic risk, whereas systematic risk is still present. The two possible solutions available to eliminate systematic risk are either through hedging or insurance. With hedging, futures or forward contracts are to be sold which, unfortunately, were unavailable on the S&P 500 in 1981. Therefore, the only way available to the institutional investors to eliminate the risk of decline in value of the portfolio was through portfolio insurance, whose use had been pioneered by LOR in 1981.

2. Portfolio Insurance

The whole idea of this portfolio insurance came from the need of institutional investors; mainly pension fund community to eliminate the downside risk of the portfolio while still enjoying the appreciation. Hedging differs with portfolio insurance in a way that it locks the exposure of the investor’s i.e. sheds exposure to both upside & downside moves. There was a fair chance that pension fund community would be attracted to portfolio insurance, as it cannot afford a decline in pension fund’s value because the return on investment is the main determinant of the pension to employees, once they commence retirement after reaching the end of their working lives. Further, there were certain restrictions imposed upon on pension fund community which only permitted it to invest a smaller proportion of funds in equity, as they are much prone to risk and with the introduction of portfolio insurance it gave the pension fund community an opportunity to invest a larger proportion of funds in equity and enjoy the luxury of earning higher returns on stock with the limited downside. 

These benefits can only be obtained in exchange for the advance payment of an insurance premium to a person or company that underwrites the insurance risk, insurer, and guarantees the floor value of the portfolio. In 1981, $266 billion worth of pension funds investment was in equities, and the principals at LOR were of the opinion that there innovation might attract considerable proportion of these assets. The investment of the pension fund community in equities was growing, and it almost got thrice and increased to approximately $744 billion before the market the market crash of October, 19, 1987.

The Portfolio insurance may also be referred to as long a put option on the underlying asset i.e. the portfolio investment in equities. The holder of the put option has the option to sell the asset back to the writer of the option at a specified exercise price and at aspecified maturity date. This option will be exercised, if the value of the underlying is less than the strike/ Exercise price. In this strategy, the investor holds both the put option and the underlying; it is also referred to as protective put strategy. This strategy is mostly dependent on the counterparty and works only, if it is willing to underwrite the particular put as required by the investor in exchange of reasonable premium, without the investor bearing significant credit risk to the counterparty. There will be significant credit risk, if the financial position of the put writer is not sound enough, and it faces going concern problems. In this situation, there would be no benefit of purchasing put option on the underlying asset, if it expires in the money and the counter party is unable to purchase the asset at the specified exercise price.

Unfortunately, in 1981, the market for options did notexist, and in order to meet the latent demand for portfolio insurance, the principals at LOR have to design a strategy to manufacture the puts, and hence earn premiums from selling it. Therefore, they used the academic work of Fischer Black, Myron Scholes, Robert Merton and refined their work on option pricing theory to meet the latent demand of the institutional investors of portfolio insurance. The principals at LOR recognized that investors were solely interested in puts, and their refined work on option pricing technology would assist a vast deal to manufacture the puts and even calls by providing a set of instructions.

The intuition that resulted in option pricing models was the belief that an option could be reproduced. The model provides the instructions, when implemented leads to a replicating portfolio which uses the underlying asset (such as S&P 500 stocks) and investments in risk free assets (such as treasury bills), and whose payoff is similar to the payoff of a put option as demanded by the investors. 

The put can be manufactured by taking a long position in the underlying asset and then by creating a replicating portfolio in such a manner that any changes in the price of the underlying is offset by changes in the value of the replicating portfolio i.e., as the price of the stock rises, value of the replicating portfolio declines and vice Versa. The replicating portfolio can be created by calculating the value of the put option using the Black Scholes Merton model, and then calculating the delta of the option which measures the rate of change in the value of the option for a dollar change in the value of the underlying. The delta of the put is negative, as the value of the put option increases, when the value of the underlying decreases and vice Versa. The delta of a put option is between -1 and 0. Assuming, the underlying stock price does not change, the delta of an out of the money put approaches closer to 0 as time passes and the delta for in the money put approaches -1 as time passes. The below graph, figure 1,  depicts the behavior of both call & put option deltas, as they move from being out of money to in the money. Figure 2 depicts the relationship between the movement in stock price and the change in value of the delta of an option.

The calculated delta of an option can then be used to determine the incremental short position needed in stocks and long position in risk free asset. As, the value of the underlying price changes, the delta of the option changes, and hence the replicating portfolio needs to be balanced to offset the effect. The reason that this whole process is called “Dynamic Hedging” is because the replicating portfolio needs to be adjusted continuously. The above figure 2 also illustrates that as the price of the stock goes up, the value of the put decreases, which also results a decrease in the delta of the option (ignoring the negative sign). Therefore, lower value of the short position in the underlying stock is required now, and the replicating portfolio needs to be adjusted by buying the stock against the short position and liquidating a portion of risk free asset. This process of manufacturing the put necessitates the continuous rebalancing of the replicating portfolio which results in high transaction costs, for example, commissions, bid ask spread on selling and purchasing of stocks.

3. Marketing of Portfolio Insurance

Despite its attractions and latent demand, the principals at LOR’s were unable to sell the product, as they would have expected. Because of the complexity & unawareness of the product in the financial market, John O’Brien along with other two principals at LOR’s have to spent a tremendous amount of time for the first four years of the launch of the product in educating the pension fund managers regarding the benefits of the product and how it works. LOR faced obstacles even in selling to those investors who wanted to prevent a decline in their portfolio value. Most of those investors had their reservations regarding the product due to the complex mathematics involved in the option pricing theory and feared the dynamic strategy, because it might be extremely costly for them to implement, as there would be required to carry out frequent trades to balance the portfolio to continue to produce the desired put. Some investors also had their reservations regarding the image of LOR, as it was a new firm and hugely untested, and therefore, they were not willing to risk a substantial investment to a new firm.