1995•Review of Financial StudiesOpen access

A General Equilibrium Model of Portfolio Insurance

Suleyman Basak

Abstract

This article examines the effects of portfolio insurance on market and asset price dynamics in a general equilibrium continuous-time model. Portfolio insurers are modeled as expected utility maximizing agents. Martingale methods are employed in solving the individual agents’ dynamic consumption-portfolio problems. Comparisons are made between the optimal consumption processes, optimally invested wealth and portfolio strategies of the portfolio insurers and “normal agents”. At a general equilibrium level, comparisons across economies reveal that the market volatility and risk premium are decreased, and the asset and market price levels increased, by the presence of portfolio insurance.

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Key concepts: Portfolio insurance, Portfolio, Replicating portfolio, Post-modern portfolio theory, Economics, Portfolio optimization, Merton's portfolio problem, Volatility (finance)