PORTFOLIO INSURANCE DYNAMIC ASSET ALLOCATION STRATEGY

COURSE CODE F-503

GROUP: FINANCE
UNIVERSITY OF DHAKA
PREPARED FOR
Dr. Mahmood Osman Imam
Professor of Finance
Department of Finance
University of Dhaka

March 28, 200..

Dr. Mahmood Osman Imam

Professor of Finance
Department of Finance
University of Dhaka
Dear Sir,
It is my immense pleasure to submit my class report as you asked me to prepare
and submit as a requirement of Financial Derivatives course (F-503) on "Portfolio
Insurance Dynamic Asset Allocation Strategy ".
I have tried my best to compile the pertinent information as comprehensively as
possible and if you need any further information, I will be obliged to assist you.
Thanking you,
----------

ACKNOWLEDGEMENTS
At first I would like thank our course teacher Dr. Mahmood Osman Imam for giving
us such an important job like managing the portfolio insurance using dynamic asset
allocation strategy.
During the preparation of the report we did have some problem that has been
erased out with your propound lecture and assistance. Without your cooperation

and guideline this report would have been an incomplete one. Finally thank you for
your supportive thought and kind consideration for formulating an idea.

Table of Contents
1. Executive Summary
2. Management of Equity Risk
3. Asset Allocation Strategies
4. Portfolio Insurance
5. Dynamic Asset Allocation Strategy
6. Industry Analysis
7. Company Analysis
8. Information
9. 100% Equity Investment
10. 50% Equity and 50% Bond Investment
11. Delta Calculation
12. Graphical Presentation:
Static Approach
Delta
Dynamic Approach
13. References

EXECUTIVE SUMMARY
This report PORTFOLIO INSURANCE DYNAMIC ASSET ALLOCATION STRATEGY " is
prepared to fulfill the partial requirement of Financial Derivatives course (F-503) of
MBA Program of UNIVERSITY OF DHAKA.
The objective of this report is to find out how equity risk can be managed (either
eliminated or reduced) through dynamic asset allocation. This report discusses the
ways of handling the risk arising from holdings of portfolio of risky assets and
riskless assets that means how to manage insured portfolio which is a hedging
technique frequently used by institutional investors when the market direction is
uncertain or volatile. Portfolio insurance is a dynamic trading strategy designed to
protect a portfolio from market declines while preserving the opportunity to
participate in market advances.
Several portfolio insurance methods exist and are used in practice. The best known
strategy involves trading in real and / or synthetic options. For some reasons,
most investors prefer not to use the option market for insuring the portfolio. Hence
it calls for the dynamic trading strategy replicating the option strategy to insure the
portfolio. In this strategy, the manager replicates an option through continuously

revising the proportions of a portfolio consisting of the underlying risky asset

(stock/bond) and the riskless asset (bond/T-bill) to insure portfolios value.
In this report I have to analyze the industry and company to select the securities to
invest. First I construct two portfolios one investing 100% in equity another
investing 50% in equity and 50% in bonds. Total amount of investment is 5,00,000
taka. And assumed bond rate was 7%. After static approach I found out Delta. Delta
tells us the number of shares to be hold to hedge the portfolio. Delta is the
differences between higher and lower value of 50% equity investment divided by
the differences between higher and lower value of 100% equity investment. Here I
assume that there is a 90% chance to realize the higher value and 80% chance to
realize the lower value. Then I assign the portfolio according to delta and find out
the insured value.
Management of Equity Risk
Management of equity risk refers to either eliminate or reduce the risk associated
with equity securities through the use of derivatives and dynamic asset allocation.
Equity risk refers to variation in the value of individual shares of that of an equity
portfolio. Equity risk essentially a price risk.

Asset Allocation Strategies

Establishing an appropriate asset mix is a dynamic process that may be the most
important determinant of your portfolio's overall risk and return. Your portfolio's
asset mix should reflect your goals at any point in time. There are a few different
strategies of establishing asset allocations, and here we outline some of them and
examine their basic management approaches.
Strategic asset allocation is a method that establishes and adheres to what is called
a "base policy mix." This is a proportional mix of assets based on expected rates of
return for each asset class. For example, if stocks have historically returned 10% per
annum and bonds have returned 5% per annum, a mix of 50% stocks and 50%
bonds would be expected to return 7.5% per year.
Strategic asset allocation generally implies a buy-and-hold strategy, even as the
inevitable shifting values of assets will result in a drift from the initially established
policy mix. For this reason, investors may choose to adopt a constant-weighting
approach to asset allocation, in which the portfolio is continually re-balanced. For
example, if one asset were declining in asset value, investors would purchase more
of that asset class due to its "cheap" status, and if that asset value should increase
in value it would be sold because it has become "expensive." There are no hardand-fast rules for the timing of portfolio re-balancing under strategic or constant-

weighting asset allocation. However, a common rule-of-thumb is that the portfolio

should be re-balanced to its original mix when any given asset class moves more
than 5% from its original value.
Over the long run, a strategic asset allocation strategy may seem relatively rigid.
Therefore, the investor may find it necessary to occasionally engage in short-term,
tactical deviations from the mix in order to capitalize on unusual or exceptional
investment opportunities. This flexibility adds a component of market timing to the
portfolio, allowing investors to participate in economic conditions that are more
favorable for the performance of one asset class than for others.
Tactical asset allocation can be described as a moderately active strategy, since the
overall strategic asset mix is returned to when desired short-term profits are
achieved. This strategy demands some discipline from the investor or portfolio
manager, as he or she must first be able to recognize when short-term opportunities
have run their course, and then re-balance the portfolio to the long-term asset
position.
Another active asset allocation strategy is dynamic asset allocation, in which the
mix of assets is constantly adjusted as markets rise and fall and the economy
strengthens and weakens. Because it sells assets that are declining in value and
purchases assets that are increasing in value, the dynamic asset allocation is the
polar opposite of a constant-weighting strategy. For example, in a dynamic portfolio,
if the stock market is showing weakness, stocks are sold in anticipation of further
decreases in stock values, and if the market is strong, stocks are purchased in
anticipation of continued market gains.
Under an insured asset allocation strategy, a base portfolio value is established
under which the portfolio should not be allowed to drop. As long as the portfolio
achieves a return above its base, active management is exercised to try to increase
the portfolio value as much as possible. If, however, the portfolio should ever drop
to the base value, all assets are invested in risk-free assets so that the base value
becomes fixed. At such time, the investor would consult with his or her advisor on
re-allocating assets, perhaps changing his or her investment strategy entirely. An
insured asset allocation strategy can be implemented by way of a formula approach
or a portfolio insurance approach. The formula approach is a graduated strategy: as
the portfolio value decreases, more and more risk-free assets are purchased so that
when the portfolio reaches its base level it is entirely invested in risk-free assets.
The portfolio insurance approach uses put options and/or futures contracts to
preserve the base capital. Both approaches are considered active management
strategies, but when the base amount is reached, a passive approach is adopted.
Insured asset allocation would be suitable to risk-averse investors who desire a
certain level of active portfolio management but appreciate the security of
establishing a guaranteed floor below which the portfolio is not allowed to decline.

For example, an investor who wishes to establish a minimum standard of living

during retirement might find an insured asset allocation strategy ideally suited to
his or her management goals.
Integrated asset allocation ensures that both economic expectations and client risk
are considered in establishing an asset mix. While all of the above-mentioned
strategies for asset allocation take into account expectations for future capital
market returns, not all of the strategies account for investment risk tolerance.
Therefore, integrated asset allocation includes aspects of all strategies, accounting
not only for expectations but also actual changes in capital markets and the
investor's risk tolerance. Integrated asset allocation is a broader asset allocation
strategy, albeit one allowing for only one of dynamic or constant-weighting
allocation--obviously, an investor would not wish to implement the aspects of two
strategies that are competing with one another.
Asset allocation can be an active process in varying degrees or strictly passive in
nature. Whether an investor chooses a precise asset allocation strategy or a
combination of different strategies depends on that investor's goals, age, and risk
tolerance. Keep in mind, however, that this article gives only general guidelines on
how investors may use asset allocation as a part of their core strategies. Be aware
that allocation approaches that involve anticipating and reacting to market
movements require a great deal of expertise and talent in using particular tools for
timing these movements. Some would say that accurately timing the market is next
to impossible, so make sure your strategy isn't too vulnerable to unforeseeable
errors.
Portfolio Insurance
The financial product known as portfolio insurance was born the night of September
11, 1976. Hayne Leland had recently returned from France, and had been
lamenting the weakness of the dollar. Portfolio insurance is a dynamic trading
strategy designed to protect a portfolio from market declines while preserving the
opportunity to participate in market advances.
An early criticism of portfolio insurance was that it reduced return as well as
reducing risk. But users are discovering that portfolio insurance can be used
aggressively rather than simply to reduce risks. Long-run returns can actually be
raised, with downside risks controlled, when insurance programs are applied to
more aggressive active assets. Pension, endowment, and educational funds can
actually enhance their expected returns by increasing their commitment to equities
and other high-return sectors, while fulfilling their fiduciary responsibilities by
insuring this more aggressive portfolio. Compared with current static allocation
techniques, annual expected returns can be raised by as much as 200 basis points
per year.

Properties of Insured Portfolios:

The return pattern of the insured portfolio has several important properties:
(A) The probability of experiencing any losses is zero.
(B) The return on any profitable position will be a predictable percentage of the rate
of return that would have been earned by investing all funds in the S&P 500.
(C) If the portfolio is restricted to investments in the S&P 500 and cash loans, if the
expected rate of return on the S&P 500 exceeds the return on cash, and if the
insurance is fairly priced, then among all investment strategies possessing
properties (A) and (B), the insured portfolio strategy has the highest expected rate
of return.

Dynamic Asset Allocation Strategy

In this strategy, the manager replicates an option through continuously revising the
proportions of a portfolio consisting of the underlying risky asset (stock/bond) and
the riskless asset (bond/T-bill) to insure portfolios value.
This strategy requires buying more stock when the market is going up and selling
off some stock as the market is goes down.
The proportions allocated to the underlying risky asset and the riskless asset
change every period, so this strategy requires a significant amount of trading.
The number of units of the underlying risky asset that must be held long at any
given moment will be given by the call options Delta, the reciprocal of how many
calls it takes to hedge a unit of the underlying portfolio. The call delta tells us the
number of units of the underlying portfolio to hold.
The amount of riskless asset to hold is determined by subtracting the value of the
units held in the underlying asset from the total value of the insured portfolio.
Industry Analysis
An investor who is convinced that the economy and market are attractive for
investing should proceed to consider those industries that promise the most
opportunities in the coming years. The significance of industry analysis can be

established by considering the performance of various industries which are shown in

the following table:
Sectoral Performance in October, 2004

Sector

Market Capitalization

Turnover (Tk. in
mn)

End of the End of the % of

Current last Month total
Month (September Market
(October)
) Cap

For the
For this
Month % of
Month Septemb total turno
October
er ver

Financial Institutions

Banks

85,075

62,019

9,584

8,051

4.99

147.8

270.48

2.43

1,920.85

1,515

40.03

47.95

0.66

Foods

11,234

11,359

5.85

133.23

127.23

2.19

Pharmaceuti
cals

29,478

28,602

15.35

579.98

832.78

9.53

Textile

8,553

7,746

4.45

278.51

483.27

4.58

Engineering

8,277

7,162

4.31

340.31

240.66

5.59

823

916

0.43

25.24

38.97

0.41

Insurance

Investment

44.29 3,706.44 2,808.69

60.93

Manufacturing

Ceramics

Tannery

3,666

3,498

1.91

123.78

176.79

2.03

Paper &
Printing

184

222

0.1

0.99

3.49

0.02

Jute

143

133

0.07

0.22

0.24

23,337

22,148

12.15

339.11

258.61

5.57

Cement

Service & Miscellaneous

Fuel &
Power

4,628

4,231

2.41

42.99

18.87

0.71

Service &
Real Estate

1,274

1,224

0.66

49.01

59.9

0.81

IT

1,131

933

0.59

118.63

142.82

1.95

Miscellaneo
us

2,253

2,024

1.17

158.61

137.55

2.61

According to the performance of different sectors I select five companies from five
sectors which are: Bank, pharmaceutical, textile, food and engineering.
The top five sectors according to turnover are:
1. Banks
2. Pharmaceuticals and Chemicals
3. Engineering

4. Cement
5. Textile.
The top five sectors according to market capitalization are:
1. Banks
2. Pharmaceuticals and Chemicals
3. Cement
4. Food
5. Insurance
6. Company Analysis
7. Once market analysis has indicated a favorable time to invest in common
stocks and industry analysis has been performed to find those industries with
the most promising future, it remains for the investor to choose promising
companies within those industries. In doing company analysis an investor
should think in terms of the two components of fundamental value
dividends and required rate of return or alternatively, earnings and the P/E
ratio.
8. Companies are analyzed through the study of wide range of data, including
P/E ratios, EPS, NAV per share, net profit or loss after tax, reserve and
surplus, market categories and so on. According to these criteria of company
analysis I selected the following companies which are shown in the following
table-

Name of the
Company

Marker
Category

Reserve
&
Surplus

Net Profit/(Loss)
after Tax (Tk.
Mm)

EPS

P/E
Ratio

Dhaka Bank

589.49

269.01

50.65

14.62

Singer
Bangladesh

86.01

129.28

77.78

21.83

Padma Textile

1174.91

78.43

9.49

10.47

British
American

1708.79

871.31

14.52

9.99

Tobacco

ACI Limited

186.86

85.41

5.28

16.43

9.
There are four category A, B, G and Z. The turnovers of A category
companies are higher than other categories (B, G, Z).
10.
References
11.Managing Equity Risk: Strategies, Stock Index Future, And Portfolio Insurance
12.Options, Futures and Other Derivatives, John C. Hull
13.Fundamental of Investment, Charles P. Jones, Frank k. Reilly, Keith C. Brown
14.The Evolution of Portfolio Insurance, Hayne E. Leland and Mark Rubinstein
15.(Published in Dynamic Hedging: A Guide to Portfolio Insurance,
16.edited by Don Luskin (John Wiley and Sons, 1988)
17.
Websites:
18.www.dsebd.org (Dhaka Stock Exchange)
19.http://www.secbd.org (Securities and Exchange Commission, Bangladesh)
20.www.investopedia.com
21.www.dynaporte.com
22.www.in-the-money.com