A Study on Portfolio Insurance Strategies on Indian Equity (Nifty 50)

 

Lakshmi Y, Ajay R, Uday Kumar Jagannathan

Faculty of Management and Commerce, Ramaiah University of Applied Science, Gnanagangothri Campus,

M S R Nagar, Bengaluru -560054, Karnataka, INDIA 

 

ABSTRACT:

Portfolio Insurance Strategies are the investment strategies used by the investors to avoid their losses by using various financial instruments such as equites and debts and derivative are combined in such a way that degradation of portfolio value is protected. It is a dynamic hedging strategy which uses stock index. It implies buying and selling securities periodically to maintain limit of the portfolio value. The working of portfolio insurance is similar to buying an index put option and can also be done by using listed index options. Due to the possibility of gaining advantages from these strategies, investor can opt these strategies according to the market conditions to maximize their returns. The study focuses on eight Portfolio Insurance Strategies: Synthetic Call, Covered Call, Long Combo, Synthetic Put, Covered Put, Long Straddle, Short Straddle, Long Strangle Strategies, these strategies can be called Portfolio Insurance Strategies because of their nature of investment and returns. The objectives of the study to analyze the risk and return associated with these strategies on 5 years historical data of Nifty 50 and formulated hypothesis to know impact of variables such as Risk, Volatility, Degree of Risk. The study Concluded that Insurance Portfolio Strategies are more beneficial for the investors who uses them according to the market conditions.

 

 

 

INTRODUCTION:

Financial instruments are traded enormously in the Stock market across the world since decades. Though these financial instruments are traded over the stock exchanges over few decades, but their existence have been through centuries. These instruments are attractive to the investors because of their leverage but many investors fail to extract the leverage associated with it. The reason behind those failures may be due to lack of knowledge about when to use these instruments in various market conditions.

 

These instruments bring in very attractive leverage and have been invented for the purpose of hedging but more than 80% of these contracts are traded merely for speculative purposes. Due to speculative trading, these types of instruments have been blamed for the financial meltdown and sudden market crashes usually known as Black days.

 

One of the worst days ever in the US stock market also known as the Black Monday of 1987 saw the Dow Jones plunge around 22.61 % in a day. The crash began in Hong Kong and soon spread to US and Europe. The most popular explanation for the cause of this market crash was Portfolio hedging and computerized selling. The US market has witnessed many such crashes thereafter due to speculative used of such instruments.

 

After the boom of online trading there has been increase of retail traders using such financial instruments. Worst part is these traders are not well equipped to trade such complex instruments and do not know the consequences and risk involved. In order to overcome these problems of investors portfolio Insurance Strategies can be used.

 

Portfolio Insurance:

Portfolio Insurance is a method of hedging a portfolio of Stocks against the market risk. This hedging technique is frequently used by institutional investors when the market direction is uncertain or volatile. Portfolio insurance is an investment strategy where various financial instruments such as Equites, Debts and Derivatives are combined in such a way that degradation of portfolio value is protected. It is a dynamic hedging strategy which uses stock index. It implies buying and selling securities periodically to maintain limit of the portfolio value. The working of portfolio insurance is akin to buying an index put option and can also been done by using listed index options. Portfolio Insurance acts as a general insurance for a portfolio where it stops losses and investor can be risk free of not sinking into deeper loses.

 

National Stock Exchange of India Limited:

The National Stock Exchange of India Limited (NSE) was established in the year 1992, located in Mumbai. NSE the leading stock exchange of India. It was established as the first dematerialized electronic exchange in the country to provide a modern, fully automated screen-based electronic trading system which offered easy trading facility to the investors spread across the country.

 

National Stock Exchange is the world’s 11^th largest stock exchange as of April 2018 and has a total market capitalization of more than US$2.27 trillion. NSE's flagship index, the Nifty 50 stock index is used extensively as a barometer of the Indian capital markets by investors in India and around the world. In 1996, Nifty 50 index was launched by the NSE. However, Vaidyanathan (2016) estimates that only about 4% of the GDP is derived from the stock exchanges in India.

 

According to Economic Times, it is estimated that as of April 2018, 60 million Retail investors had invested their savings in stocks in India, either through equities or through mutual funds. Earlier, the Bimal Jalan Committee report estimated that around 1.3% of India's population invested in the stock market, as compared to 27% in USA and 10% in China.

 

LITERATURE REVIEW AND PROBLEM FORMULATION:

Literature Review:

Portfolio Insurance Strategies Background:

Portfolio Insurance strategies are designed to limit downside risk and at the same time to profit from rising markets. Portfolio insurance trading strategy which guarantees a minimum level of return at a specified time horizon, but also participates in the potential gains of a positioned portfolio. The most prominent examples of dynamic versions are the constant proportion portfolio insurance (CPPI) strategies and option–based portfolio insurance (OBPI) strategies with synthetic puts. The concept of (synthetic) option–based portfolio insurance is introduced in 1976. The constant proportion portfolio insurance (CPPI) is introduced in 1987.

 

Put and Call Option Pay Offs:

 

Figure 1. Representation of Put and Call Pay offs

The popularity of portfolio insurance strategies can be explained by various reasons. On the side of institutional investors there are regulatory requirements including return guarantees as well as requisitions on the risk profile. For example, consider the problem of an institution optimally managing the market risk of a given exposure by minimizing its Value at Risk using options.

 

Critical Literature Review:

Tony Estep, Mark Kritzman - 2016 analyzed the stock prices at different time periods and protect portfolio using put options and to reduce risk if the market falls. The study was based on secondary data. Time Invariant Portfolio Protection (TIIP) model is used and assumptions were Portfolio will never decline below a preset floor, no use of Black Sholes formula and standard deviation, Protection is continuous and has no ending date, less trading. Their findings were hedging put options can protect portfolio when market falls, and research gaps was found that are further study can be made by adding the concept of In the money, Out of the money, At the Money.

 

Madura Jaff, Tucker, Alan L (2012) focuses on risk reduction and security diversification by using hedging techniques v/s unhedging from the lessons of market crash in 1987. Secondary data used for the research two methods were used are Covariance, Simulation on the movement of stock prices. Results found that hedging plays a dominant role than unhedging when market crashes and also proved insured portfolios with put options are safest when market crashes. Further study can be done on rate of inflation and deflation against exchange rates at the time of market crash.

 

Philippe Bertrand, Jean-luc Prigent (2006) compared the CPPI with OBPI by introducing systematically the probability distributions of the two portfolio values and by comparing them by means of various criteria and also to analyse the dynamics of both methods and offer new insights into them. Conclusions where they have examined the two standard insurance strategies i.e., OBPI and CPPI to protect portfolio when market falls. They have concluded that OBPI is the best strategy to protect the portfolio when a market undergoes sudden drop.

 

Guangyuan Xing, Yong Xue, Zongxian Feng (2014) made a study on dynamic setting model of multiple for gap risk on portfolio. Secondary data was used. SV-EVT approach is used as a method for study. The authors have concluded that investors who are bearish in the market but also, they invest in stock portfolio and want to reduce their losses if the market suddenly downfalls they can use CPPI applications to benefit from this insurance strategy. They have concluded by studying the market situation, underlying asset prices for different time periods.

 

PROBLEM FORMULATION:

Research Gaps

•     The study on Portfolio Insurance strategies on Nifty 50 are limited

•     The use of Insurance Portfolio Strategies on NSE Stock is not in the literature

•     Research was made only by using traditional strategies like CPPI Strategy and OBPI Strategy

•     The analysis on portfolio insurance strategies with the help of risk volatility and return are scant

 

AIM AND OBJECTIVES:

Aim:

To interpret how portfolio insurance strategies helps the investor to mitigate loss by using historical data for the period of 2015 to 2019.

 

Objectives:

•     To obtain historical data on Nifty 50 (underlying value of share), Put and call options for 5 years

•     To calculate descriptive statistics on 8 different portfolio insurance strategies

•     To perform regression analysis on past data and estimate the impact of return and risk volatility

•     To explain my conclusions whether the portfolio insurance strategies help the investor to mitigate his loss on different market conditions

 

METHODS AND METHODOLOGY:

1	To obtain historical data on Put and call options for 5 years	Secondary Data, NSE Library, Python	Python code is written to collect the data on Nifty 50 underlying value of share, Put and call data
2	To calculate descriptive statistics on 8 different portfolio insurance strategies	Secondary data, Calculation of mean, variance and standard deviation are done to know returns, volatility, risk for 8 different portfolio insurance strategies	Descriptive statistics was done with help of excel
3	To perform regression analysis on past data and estimate the impact of return and risk volatility	Secondary data, severalhypotheses are drawn and Regression model is used as a method for solving the hypothesis	Regression is done with the help of excel
4	To explain conclusions whether the portfolio insurance strategies help the investor to mitigate his loss on different market conditions	Based on the analysis, interpretations are made, and conclusions are explained, literature review also referred	Literature review, from the analysis of problem statement

PROCEDURE FOR PROBLEM SOLVING :

 

Figure 2. Figure representing Procedure for Problem Solving

 

RESEARCH QUESTIONS AND HYPOTHESIS:

Research Question:

Apply the 8 strategies on past years (2015 to 2019) Historical data and analyse whether they help to mitigate losses of an investor.

The total number of Sample data is 153 Observations

The Software and tool used are Excel, Correlation

 

HypothesisFormulation:

Hypothesis 1:

To identify the Statistical impact of risk on return of insurance portfolio strategies.

Dependent variable: Return

Independent variable: Standard Deviation

H₀: There is no Statistical impact of risk on return of insurance portfolio strategies

H₁: There is a Statistical impact of risk on return of insurance portfolio strategies

 

Hypothesis 2:

To identify the Statistical impact of Coefficient of variation (Volatility) on return of insurance portfolio strategies

Dependent variable: Return

Independent variable: Coefficient of variation (Volatility)

H₀: There is no Statistical impact of Coefficient of variation (Volatility) on return of insurance portfolio strategies

H₁: There is a Statistical impact of Coefficient of variation (Volatility) on return of insurance portfolio strategies

 

Hypothesis 3:

To identify the Statistical impact of Variance on return of insurance portfolio strategies

Dependent variable: Return

Independent variable: Variance (Degree of risk)

H₀: There is no Statistical impact of variance on return of insurance portfolio strategies

H₁: There is a Statistical impact of variance on return of insurance portfolio strategies

 

RESULTS AND DISCUSSIONS:

Results of Descriptive Statistics on each Portfolio using Portfolio Insurance Strategies are drafted to analyse Returns, Mean, Mode, Median, Standard Deviation, Skewness, Kurtosis, Range, Maximum and Minimum returns from each strategy. Graphs are formed to show the descriptive statistics for every strategy. All the hypothesis formulated are tested and resulted in detail. The regression analysis are used to test the hypothesis.

 

Regression Statistics:

Table 7.1 Regression Statistics

 

 

SIGNIFICANCE OF NULL HYPOTHESIS:

Table 1. ANOVA Results

 

 

T Stat and P-Value

Table 2. Regression Analysis

	Coefficients	Standard Error	t Stat	P-value	Lower 95%	Upper 95%
Intercept	-19.51467	7.78726	-2.50597	0.06634	-41.13556	2.10623
X Variable 1(Standard Risk)	120.63498	23.94851	5.03726	0.00730	54.14325	187.12670
X Variable 2(Volatility)	0.39934	0.17437	2.29015	0.08384	-0.08480	0.88347
X Variable 3(Degree of Risk)	-135.22948	14.62271	-9.24791	0.00076	-175.82863	-94.63032

 

 

Table 3. Regression result for return as a dependent variable

 

 

By referring Table, it can be inferred that three variables are highly significant and explains 97.6% of the Returns.

 

The value of R square is 98.6% which indicates that a good positive percentage that validates regression analysis.

 

The variables variance have negative coefficient which indicates a negative correlation with Return whereas Standard deviation, Coefficient of variation show positive correlation with return. The variable coefficient of variation is statistically insignificant and has no impact on return as it has a p-value greater than 5%. The variables Standard deviation and variance are statistically significant and has an impact on return because their P - values are less than 0.05, where variance has shown a negative impact but standard deviation shows positive impact on returns. From this regression analysis a solution is brought for all the hypothesis which were drawn to solve the problem. Based on the P-value, Coefficients and T tests all the hypothesis are solved and rejected the null or alternative hypothesis which has not got statistical significance from the regression analysis.

 

Regression Result for Return as a Dependent Variable

Multiple R: 0.9931

R square: 0.9863

No of observations: 152

 

 

 

By referring the table, it can be inferred that out of 3 variables one variable not showing statistical impact on return. In the above table status of accept / reject implies to null hypothesis that means Reject implies reject null hypothesis and accept alternative hypothesis

 

Hypothesis interpretation:

·       The P-value for the independent variable Risk to Return was found to be less than 0.05 which implies that it positively impacts the Return of Portfolio Insurance Strategies. Hence, there is statistical impact of Risk on Return. Therefore, the null hypothesis H₀ is rejected and alternative hypothesis is accepted.

·       The P-value for the independent variable Coefficient of variation to Return was found to be more than 0.05 which implies that it negatively impacts the Return of Portfolio Insurance Strategies. Hence, there is no statistical impact of Coefficient of variation on Return. Therefore, the alternative hypothesis H₁ is rejected and null hypothesis is accepted.

·       The P-value for the independent variable Variance to Return was found to be less than 0.05 which implies that it positively impacts the Return of Portfolio Insurance Strategies. Hence, there is statistical impact of Variance on Return. Therefore, the null hypothesis H₀ is rejected and alternative hypothesis is accepted.

·       Referring below graphs as representation of payoff from Synthetic Call Strategy and Covered Call Strategy.

 

Figure 3. Figure Representing the Payoff from Synthetic Call Strategy

 

Figure 4. Figure Representing the Payoff from Covered Call Strategy

 

CONCLUSION:

Derivatives are extremely important and have a big impact on other financial market and the economy. The project is designed to upgrade investor’s knowledge with the basics of how to make investment decisions in options with reference to several market conditions. It is important for the investors that they must analyze the fundamental (Economic and Financial), technical and other factors for dealing in options. For many investors options are useful as tools of risk management

 

Apart from analyzing the fundamental factors while investing, the investor has to make strategies to safeguard himself from downfall of market. This research helps the investor to upgrade with the knowledge how to make profits in certain and uncertain conditions that means investor should know to make profits even in market downfall that can be happen through using these Portfolio Insurance Strategies

 

Different Option Strategies and the options help to earn a risk-less profit. The option strategies are used according to the nature of market condition. If market is bullish - Long Call, Covered Call is useful. In case of bearish market Long Call and Long Put option strategies is useful. In neutral option - Long Straddle is useful tool for the investment

 

Investor should always diversify his portfolio according to market conditions. It's better for every investor to be in two investment positions which are negatively correlated so that if one position makes loss the other position makes profit, the loosed portfolio claim its losses from gained portfolio. Descriptive analysis and hypothesis tests are also proved that Portfolio Insurance Strategies help the investor in different market condition in terms of their risk, return, Volatility and degree of risk.

 

SUGGESTIONS FOR FUTURE WORK:

1.     Current research was made on Nifty 50 monthly historical data from 2015 to 2019, a sample data points of 152. Further research can be done by taking 10 years sample data of Nifty 50

2.     Further research can be done using three and six month’s expiry options

3.     Current research focused on eight Portfolio Insurance Strategies, further work can be done on using several hedging strategies and applying those strategies on past years data

4.     One can develop Hedging strategies model that can be helpful for an investor to prefer strategies model while making investment

5.     Further research can be made by adding variables such as Beta and Alpha which helps one to analyse risk with these variables

6.     Further research can be made by adding the CAPM model for analysis that would more validate the results of risk and return by using Portfolio Insurance Strategies

7.     Several Hypothesis can be formulated by adding variables such as Beta and Alpha to know the impact on each of them and also with return on investment

8.     Current research focused on equity market, further research can be made on currency markets by using these Portfolio Insurance Strategies

9.     Further study can be made on different stock index of India, US and other countries

10. Current study focused on all market conditions, further study can be made on only one market condition either on rising market condition or on down falling market condition  

 

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Accepted on 29.12.2019           ©AandV Publications All right reserved