Portfolio Insurance and Volatility Regime Switching

31 Pages Posted: 8 May 2006

See all articles by Joel M. Vanden

Joel M. Vanden

Pennsylvania State University - Smeal College of Business

Abstract

A new equilibrium model of portfolio insurance is presented in order to study the volatility effects of dynamic insurance strategies. While prior research has focused on the relationship between portfolio insurance and the overall level of market volatility, this article shows that the salient feature of portfolio insurance is volatility regime switching. Regime switching is shown to be a necessary condition for portfolio insurance, which provides a new explanation for the pervasive volatility clustering effect that is found in most equity markets. The equilibrium involves a free boundary and the local time of the equilibrium price process at the free boundary plays an important role in solving the model.

Suggested Citation

Vanden, Joel M., Portfolio Insurance and Volatility Regime Switching. Mathematical Finance, Vol. 16, No. 2, pp. 387-417, April 2006. Available at SSRN: https://ssrn.com/abstract=889978 or http://dx.doi.org/10.1111/j.1467-9965.2006.00276.x

Joel M. Vanden (Contact Author)

Pennsylvania State University - Smeal College of Business ( email )

University Park, PA 16802
United States

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