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Finance, Economics, and Mathematics by Robert C. Merton, Oldrich A. Vasicek

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Chapter 26The Best-Return Strategy

Introduction

Portfolio insurance is a technique that allows the investor to participate in the upside potential of a risky portfolio (called the target asset), while reducing or eliminating the downside risk. Typically, this means guaranteeing a specified minimum return over a given investment horizon. The cost of the insurance is paid in terms of a return differential by which the investment return lags behind the performance of the target asset.

The target asset itself can be a portfolio containing a number of investment assets. For instance, the target portfolio can be a balanced fund consisting of equities, bonds, and mortgages. The allocation of funds within this portfolio can be fixed, or can vary according to a passive or active strategy. The insurance then applies to the total fund, and depends only on its total performance rather than on the performance of the individual components. Although the insured portfolio consists of multiple assets, from the viewpoint of the insurance strategy it is a single target asset.

In this chapter, we address a different type of multiple asset strategy, called the best return strategy. Instead of ensuring the performance of a combination of assets, this strategy assures that the return on the total investment will be that of the best performance of the individual assets, less the known cost of the strategy. Thus, if the individual assets are stocks, bonds, and mortgages, and if stocks happen to perform ...

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