Dynamic Securities Assets Allocation in Portfolio Insurance: The Application of Constant Proportion Portfolio Insurance and Time Invariant Portfolio Protection Methodologies in the Chinese Capital Market

The goal of this paper is to study the application of the methodologies of dynamic allocation for securities assets on the basis of option theories. In order to limit the risk of the market value fluctuating in Chinese capital market, we designed the portfolio insurance in the light of Constant Proportion Portfolio Insurance (CPPI) and Time Invariant Portfolio Protection (TIPP) methodologies. The results of the data analysis suggest that the most important consideration is to set a floor for the value of the portfolio, and then seek to achieve the maximum participation in securities markets for the rising return. 1. Problem definition and literature review Portfolio insurance originated from the option theory for portfolio of stocks and put options. But in reality, it is hard to get the perfect matched options, and it is not easy to purchase put options to fulfill the insurance concept. Black and Scholes (1973) developed the valuation formula for call options in 1973, thus the practice of the concept about portfolio insurance was initiated. Rubinstein (1985) offered the concept of replicating options of stocks and risk-free assets. In as much as there may not be suitable put options, the investors who prefer portfolio insurance can still implement the portfolio insurance methodologies to replicate the return of options through dynamic assets adjustment; thus the application of insurance methodologies in portfolio is highly feasible. Robert D. Arnott (1994) indicated that an investor who manages his assets by mostly depending on his estimation of the market, might make mistakes easily under emotion. As for the institutional investors, such as insurance, fund or securities companies, which hold many funds and many diversified portfolios, these may use some quantitative methods, such as dynamic assets adjustment methodology based on option theories, and offer an objective basis. The investors may avoid emphasizing the recent experiences and ignoring the situation about the real potential market. This is the focus of this study. The goal of this paper is to study the implications of the application of the methodologies of dynamic allocation for securities assets on the basis of option theories in the Chinese capital market by designing the portfolio insurance in the light of Constant Proportion Portfolio Insurance (CPPI) and Time Invariant Portfolio Protection (TIPP) methodologies. The dynamic assets allocation methodologies based on option theories work as follows: 1.1. High calls-low puts methodology (purchase of insurance) Synthetic puts methodology: based on the valuation model of options suggested by Black and Scholes (1973), you adjust the amount of risky assets and risk-free assets to replicate the return of European puts. Referring to the avoidance of the disturbance from the estimation of volatility rate, researchers have developed some simple methods to achieve the target of insurance without the estimation of volatility rate, mainly are Constant Proportion Portfolio Insurance (CPPI ) and Time Invariant Portfolio Protection (TIPP) methodology respectively. CPPI methodologies © Wang Tiefeng, Kami Rwegasira, 2006 Investment Management and Financial Innovations, Volume 3, Issue 1, 2006 98 Rerold (1986), Black and Jones (1987) suggested CPPI methodology. They utilize the following equation to define the amount of risky assets and the risk-free assets: Amount of risky assets invested = multiple factor x (total value of insured portfolio – initial Floor). The multiple factor and initial floor are defined at the beginning of the period and without any change. The equation for CPPI is given as: