Capital protection stratgies for investors

Capital protection strategies are a classic case of putting theory into practice. They are a product of applying option pricing theory to the very practical activity of investing. Option pricing theory itself is a relatively new field. Developments and refinements of capital protection strategies have, there­fore, been a recent phenomenon.

A capital protection strategy is the Australian equivalent to the investment strategy known as portfolio insurance in the United Sates. The objective of a capital protection strategy is ro achieve a high return when financial markets perform well, and to avoid a negative return when financial markets perform poorly. The strategy, therefore, has an asymmetric pay-off similar to that of a call option. Figure 1 contains the pay­off for a capital protection strategy and the pay-off for a passive investment strategy - one which maintains a con­stant holding of investment assets.

The horizontal axis shows the return achieved by a particular set of assets. The vertical axis shows the return achieved on each of the two strategies. The passive investment strategy achieves the same as the assets - it is a forty-five degree line. In contrast, the capital protection strategy is immune from a negative return, but achieves a high proportion of the positive returns experienced by the assets.

Illustrating the objectives of a capital protection strategy is straightforward. However, designing a strategy to achieve those objectives is challenging.

This article explores the capital protec­tion strategies used by investors. It out­lines the strengths and weaknesses of each strategy. It also discusses the practi­cal problems of implementation and the techniques to overcome these problems.