Utility Maximizing Portfolio Insurance Strategies When Hedgers Consider the Impact of Their Trading on Security Prices.

Portfolio insurance strategies can destabilize markets to such an extent that they may be counterproductive. Destabilization results when hedgers take share prices as given and follow exogenously specified price-based trading rules. We recognize that such trading rules may not be utility maximizing and that hedging affects share prices. Accordingly, we develop a portfolio insurance strategy where hedgers consider the impact of their trading on prices and endogenize their trading rule which is obtained by maximizing expected utility. Moreover, our strategy does not require the dissemination of information about the extent of portfolio-insurance based hedging activity in the economy. Copyright 1996 by Kluwer Academic Publishers