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PORTFOLIO INSURANCE AND VOLATILITY REGIME SWITCHING
Author(s) -
Vanden Joel M.
Publication year - 2006
Publication title -
mathematical finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.98
H-Index - 81
eISSN - 1467-9965
pISSN - 0960-1627
DOI - 10.1111/j.1467-9965.2006.00276.x
Subject(s) - portfolio insurance , volatility (finance) , economics , portfolio , implied volatility , replicating portfolio , volatility smile , volatility swap , equity (law) , stochastic volatility , financial economics , econometrics , post modern portfolio theory , portfolio optimization , political science , law
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.