19.13 PORTFOLIO INSURANCE

A portfolio manager is often interested in acquiring a put option on his or her portfolio. This provides protection against market declines while preserving the potential for a gain if the market does well. One approach (discussed in Section 17.1) is to buy put options on a market index such as the S&P 500. An alternative is to create the options synthetically.

Creating an option synthetically involves maintaining a position in the underlying asset (or futures on the underlying asset) so that the delta of the position is equal to the delta of the required option. The position necessary to create an option synthetically is the reverse of that necessary to hedge it. This is because the procedure for hedging an option ...

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