A Capability Study of Portfolio Insurance Strategies for ABS Funds and CDS Total Return Indices during the Subprime Crisis

Abstract

Classic portfolio insurance theory analyzes combinations of one risky asset and one risk-free asset under a certain rule of trading. Due to a specified investment horizon an investor has the choice between static strategies on the one hand and dynamic insurance strategies on the other hand. Motivated by the downturn movement of the asset-backed and mortgage-backed securities markets and the rise of credit spreads during the subprime crisis starting in 2007, the authors focus on constant mix and stop-loss strategies as well as on constant-proportion portfolio insurance and its derivative time-invariant proportion portfolio, which are well accepted in theory and practice. The authors benchmark these strategies against a standard buy-and-hold portfolio and provide information on the capability of these strategies when managing European ABS, CDS total return index, and equity indices with respect to an investor's risk appetite and risk awareness. The results support the conclusion that managing these asset classes and treating them as risky assets within active portfolio management strategies could have led to a significantly and nonrandom higher terminal portfolio wealth, allowing institutional investors to benefit from dynamic strategies even if they incorporate aggressive leverages.

TOPICS: Asset-backed securities, credit default swaps, VAR and use of alternative risk measures of trading risk, financial crises and financial market history