Value-at-Risk-Based Portfolio Insurance: Performance Evaluation and Benchmarking Against CPPI in a Markov-Modulated Regime-Switching Market

TL;DR

This paper extends VaR-based portfolio insurance to a regime-switching market model, compares it with CPPI, and finds CPPI generally offers better risk-return tradeoffs and stability.

Contribution

It introduces a regime-switching framework for VaR-based portfolio insurance and benchmarks its performance against CPPI using multiple evaluation criteria.

Findings

CPPI outperforms VaR-based strategy in risk-return tradeoff

CPPI maintains more stable returns at maturity

Regime-switching model captures market cyclical behavior

Abstract

Designing dynamic portfolio insurance strategies under market conditions switching between two or more regimes is a challenging task in financial economics. Recently, a promising approach employing the value-at-risk (VaR) measure to assign weights to risky and riskless assets has been proposed in [Jiang C., Ma Y. and An Y. "The effectiveness of the VaR-based portfolio insurance strategy: An empirical analysis" , International Review of Financial Analysis 18(4) (2009): 185-197]. In their study, the risky asset follows a geometric Brownian motion with constant drift and diffusion coefficients. In this paper, we first extend their idea to a regime-switching framework in which the expected return of the risky asset and its volatility depend on an unobservable Markovian term which describes the cyclical nature of asset returns in modern financial markets. We then analyze and compare the resulting VaR-based portfolio insurance (VBPI) strategy with the well-known constant proportion portfolio insurance (CPPI) strategy. In this respect, we employ a variety of performance evaluation criteria such as Sharpe, Omega and Kappa ratios to compare the two methods. Our results indicate that the CPPI strategy has a better risk-return tradeoff in most of the scenarios analyzed and maintains a relatively stable return profile for the resulting portfolio at the maturity.