Better Dynamic Hedging

JARROD WILCOX (JARROD WILCOX is director of advanced products at PanAgora Asset Management in Boston, MA.)

ISSN: 1526-5943

Publication date: 1 March 2001

Abstract

Many investors have been disappointed with the practical results of portfolio insurance programs, which attempt to achieve option‐like results through dynamic hedging. This article takes the simplest form of dynamic hedging, constant proportion portfolio insurance (CPPI), as a model for developing a more optimal approach. The author uses Monte Carlo simulation to model the multi‐period median growth in discretionary wealth. In addition, he constructs leverage policies that mitigate the practical drawbacks to dynamic hedging. The article also shows that self‐imposed ex ante borrowing constraints (not the ex post constraint imposed by a margin call) can, under certain conditions, improve the performance of dynamic hedging with respect to median terminal wealth.