Publicado nas Atas da Conferência do CEMAPRE, ISEG, 2002

PORTFOLIO INSURANCE AND VOLATILITY IN PORTUGUESE FINANCE MARKET

Elisabete Mendes Duarte∗

José Alberto Soares da Fonseca∗∗

ABSTRACT

Portfolio insurance is a technique of minimizing financial risk, based on option pricing theory. In this method,
the delta measure of an option price is used to determine the proportions in which the underlying security is
combined with a risk-free asset.
One important drawback in this technique is the fact that the volatility of the risk assets is often time varying,
contrary to what is assumed on most of the current option pricing formulas. As a result, in periods of low
volatility, portfolio insurance seems to be very efficient in capturing the gains of rising market prices, while
supplies protection against falls in market prices declines. However, when the volatility is high, especially on the
downside of the market prices, a divergence from the stated goals tends to occur. This result has already been
detected by our research in Portuguese Finance Markets.
Because volatility plays an important role in financial assets valuation in general, and in particular in options,
there is substantial literature devoted to its specification and measurement. In order to treat this problem in the
Portuguese case, we selected three methods of volatility estimation: historic volatility – the standard deviation of
a stock return; implied volatility – the volatility that, in Black-Scholes option valuation formula, equates
theoretical and market value of an option; deterministic volatility – which states that volatility is time dependent
on variables that are known on the market
In this article we test the effect of using alternatively, historic, implied and deterministic volatility in portfolio
insurance on the Portuguese Finance Market. The purpose of this work is to show the importance of rigorous
treatment of volatility to obtain the best results in portfolio insurance.

Keywords: Portfolio insurance, implicit volatility, ARCH and GARCH models.

∗
(eduarte@estg.iplei.pt); Dep.de Gestão e Economia - Escola Superior de Tecnologia e Gestão -
Instituto Politécnico de Leiria - Morro do Lena – Alto do Vieiro - 2401-951 Leiria - Phone: 244 820
300 - Fax: 244 820 310
∗∗
(jfonseca@sonata.fe.uc.pt); Grupo de Estudos Monetários e Financeiros - Faculdade de Economia -
Universidade de Coimbra - Av. Dias da Silva , nº165 - 3004-511 Coimbra - Phone: 239 790 500 - Fax:
239 403 511

1
 INTRODUCTION

Options valuation is the subject of a wide collection of studies. The importance of the subject is a consequence
of the strong diffusion of these derivatives, but option valuation theory also offers a wide collection of
applications that are especially useful in several domains of management.
Options valuation is performed, usually, by checking the stochastic process followed by the underlying stock.
Within these models the most widely used is the Black-Scholes model (1973). In fact Black-Scholes model was
the breakthrough to the development of options pricing theory. The main reason behind its success is the fact that
the formula uses parameters that, in general, are observable (volatility is the exception), and it allows for the use
of a closed formula to obtain the prices of the options. The formula has two quite attractive characteristics for
investors: it is easy to compute and the results are rapidly obtained.
A significant number of authors developed models in option pricing theory. Some of the formulas produced,
although allowing results closer to reality, never had the popularity of the original formula. Therefore, despite
the diversity of models in this area, Black-Scholes model is, even today, a reference for every analyst and
researcher that works with derivative markets.
One of the most controversial applications of options theory is the portfolio insurance strategy. Although there
are several nuances of this strategy, this article will concern only the original one, described by Leland (1980)
and Leland and Rubinstein (1981). This hedging strategy is based on the Black-Scholes option valuation formula,
synthetic options and put-call parity. This technique aims to guarantee that the value of a given portfolio does not
fall below a specified limit (the floor), although it captures the stocks valorisation.
The Black-Scholes model is, however, based on a set of restrictive hypotheses that are necessary to guarantee its
validity. These hypotheses are concerned with the stochastic process followed by the underlying assets and the
characteristics of the capital markets. Therefore, despite the popularity and general acceptation, there is a wide set
of limitations to the Black-Scholes model. One of the most difficult problems to solve is the fact that the model
admits that the underlying stocks volatility is constant. In fact the volatility is not constant, which leads to the
fundamental question of settling the values that it takes during the period under analysis.
When a portfolio insurance strategy is carried out, a portfolio is built composed of securities with and without
risk. To make sure that the stated goals are obtained, it is necessary to rebalance the portfolio whenever
necessary, according to the evolution of the finance market. To adjust the composition of the portfolio, it is
necessary to calculate the put option price according to Black-Scholes model, which is also the function of the
volatility that will have to be estimated. A misestimate of this variable will lead, in the case of underestimate, to
subvalue, and in the case of overestimate to overvalue the put option. In the first case it can lead to a larger
application, than the advisable, in the stock, from where larger gains in the case of market rising prices will
result, but from which a fall of the portfolio below the floor can also result in the case of a falling market. In the
second case the protection provided by the insurance program will be larger, it will lead to the results wished for
in the case of a falling market, but in the opposite case some valuation potential can be lost. We can conclude
that it is very important that correct estimates of the future volatility are made to guarantee the success of this
strategy1.
Note that volatility has implications on the final result obtained by portfolio insurance strategy, but the use of
such strategy has also implications on market volatility. Besides the importance of this second problem, this
question is not treated in this article.
In point 1. the portfolio insurance technique is presented according to the original model. In point 2. a
description of the different models to estimate volatility is made, giving a special emphasis to the models that
will be applied in the empirical estimation. In point 3. the volatility modelling of PSI-20 is presented. Initially a
characterization of the series is made and later the historical, implicit and deterministic volatility modelling. In
point 4. an empirical application of portfolio insurance is made according to the three volatility forecasts
modelled in the previous point. Finally, in point 5. conclusions are presented.

1
Leland (1986) said: “ Note that hedging on a simple Black-Scholes approach can get into trouble with
unexpected volatility. This is because the Black-Scholes approach assumes volatility is constant and known in
advance.
More sophisticated techniques are welded to handle the “real world””
2
 1. PORTOLIO INSURANCE

Portfolio insurance is based on option theory. The main attraction of options results from its asymmetric
profit/loss profile. The technique of portfolio insurance intends to reproduce the profile of profit/loss of a
portfolio constituted by the stock and the respective european put option.

Graph 1–Profile of S+P

Profit
S

S+P
P

Premium

Loss

Attempt in graph 1 where S represents the market value of the underlying stock, E the exercise price of the put
option and P the put option price. Note that the simultaneous purchase of the underlying stock and the respective
put option gives us a profit profile very similar to the one of the call option. It means that if we acquire the stock
and the put option simultaneously we guarantee that, at least, the underlying stock can be sold by the exercise
price. That will happen if there is a fall in the finance market and the option buyer decides to exercise it. If the
underlying stock has been acquired for the same value a null gain is obtained, which means that the use of the
strategy has a loss equal to the premium of the option. The fundamental attraction of the strategy is that the gains
are not limited. Starting from the moment where the market value of the underlying stock is larger than the
exercise price, the investor does not have advantages in exercising it, so he has a gain equal to the market value
of the underlying stock at expiry date less the cost of the underlying asset at the beginning of strategy
implementation and the premium that he pays for the option. It means that with a small cost (the premium of the
put option) a maximum loss is guaranteed equal to the premium, not committing however, the profit potential
associated to a rising market.
When a put option is directly used to hedge the risk of the underlying stock, we have a static hedging strategy.
When instead of the put option its synthetic equivalent is used, we have a dynamic hedging strategy because
options values are time variant and the strategy has to be readjusted periodically.
Notice that static hedging is very restrictive for the investors. It means to limit the hedging strategy to the stocks
for which there is options in the market and, simultaneously, to limit the temporal horizons to those of put
options (that are usually shorter than those for which we wish to use this strategy). It is also difficult to purchase
a put option, under the conditions required by the investor, in illiquidity markets.
Thus, the technique of portfolio insurance duplicates the put option itself and the strategy is developed only with
positions in stocks and cash.
To meet the synthetic equivalent of put option we start from the delta of an option. The delta is the measure of
the sensibility of the option price to the price of the underlying stock, and is widely used as a hedge ratio in
stocks hedging strategies that involve options. This measure is used to determine the amount of options to
acquire for unit of underlying stock to guarantee a risk-free portfolio. It is verified that the price of a put option
and the one of the underlying stock varies in inverse proportion. If the price of the underlying stock increases
then the price of the put option will decrease in a proportional amount. That means that a risk-free portfolio can

3
be built by acquiring a put option and δ of the underlying stock (notice that this strategy only works when
there are no great price oscillations and in short time intervals). So:

P + δ S = M (1)
As this portfolio has no risk, it should provide a profit equal to the risk-free rate presented in this equation by a
placement at a risk-free rate of an M amount. From the same equation it can be deduced:

P = M − δ S (2)

That means that the put option can be duplicated by placing M (equal to P + δ S ) at a risk-free rate and selling
short δ units of the underlying stock. Then, attempting previous results we have:

P+S =M −δ S+S (3) ⇔

P + S = M + (1 − δ )S (4)

So we can duplicate P+S placing M (equal to P + δ S) (

at a risk-free rate and applying 1 − δ )S to the
underlying stock. The strategy of portfolio insurance is developed based on this last equation. Notice that this
strategy duplicates a european option, so the results only approach the intended ones in the terminus of temporal
application. However, for that established date the strategy enables the results proposed independently of the
path followed by the stock return.
Because it works with synthetic options, there is freedom to choose temporal horizons, amounts and exercise
prices, this is a great advantage of this management strategy.
In the empiric analysis presented in point 4. of the present article, we ignore transaction costs. This question
widely discussed in literature, led to posterior developments in the original technique that we do not discuss in
this article. The reason concerns the fact that here we wish to compare the better/worse performances of the
strategy according to the used volatility estimate. Once the transaction costs equally affect all the results, we
simplify the analysis by not considering it.

2. VOLATILITY

The simpler way to estimate volatility is by means of historic volatility. This estimation method consists of
computing the standard deviation of the return of a financial asset, for a period previous to the one we are
working with. This kind of estimation has a basic objection to its use, the relevant volatility is always the future
and not the past, and the two of them will hardly be equal2. However historic volatility can also be relevant
because of the contribution it gives to expectations, we frequently verify that there is temporal correlation
between series.
Implied volatility is a method that uses Black-Scholes model itself. We take the market price of an option and
find the volatility value of the model that equates the market and the theoretical prices. If we admit that such a
model of option valuation is usually used in the market, the result we obtain will be the expected value of
volatility to investors for the duration of the option. That is why implied volatility is better in forecasting the
future volatility than historic volatility.
In time series of financial assets returns, large changes frequently succeed others, although sometimes, they do
not occur in the same direction. Statistically, this means that we are in the presence of a strong autocorrelation in
the squares returns, so variance has a temporal dependence. That is what we try to model through deterministic
volatility. Deterministic volatility is observed when its changes are a function of known variables, such as historic

2
Fischer Black himself claims, in 1976, that the hypotheses of taking historic volatility as a good measure of
volatility was quite unreasonable.
4
returns and past volatility. ARCH (Autoregressive Conditional Heterocedasticity) and GARCH (General
Autoregressive Conditional Heterocedasticity) are the commonest models used to estimate deterministic
volatility. With these models it is possible to show some important statistical properties of time series, and they
also offer advantages in the forecast domain. Once combined, these points lead ARCH models to be of vital
importance to compute volatility of financial markets .
To use ARCH processes to forecast the volatility of a stock means, however, that the Black-Scholes model is no
longer correct to do the options evaluation. That can be an obstacle for the present empiric study, because
portfolio insurance is based on this model.
Duan (1995) develops a model for option valuation, which presupposes that the volatility of the underlying asset
follows a GARCH process3. In this model an intensive procedure of calculation is used to estimate the return and
the volatility under a risk-neutral distribution. The model of Duan uses the same variables of the Black- Scholes
model, plus one variable representing the process followed by the volatility, and another variable representing the
excess return of the underlying asset over the risk-free interest rate. Thus, this model depends on investors’
preferences and Duan has demonstrated that, under a risk-neutral distribution, a negative correlation is observed
between the conditional variance and the historical returns of the underlying asset, when its risk premium is
positive. Bates (1995) demonstrates that this is a general characteristic of the empirical data. Duan’s model has,
thus, the advantage of calculating options prices that are consistent with the bias in volatility. It is the time
required and the complexity of the calculation of option prices using this method that explain the common use of
the Black and Scholes formula with ARCH volatility, even among researchers. Engle, Kane and Noh (1994) have
demonstrated, using the S& P 500 index, that the results obtained with Black-Scholes formula can be improved if
a GARCH process is admitted for volatility.
Therefore, although knowing that it is not theoretically correct, we choose to apply the forecast results of ARCH
models in portfolio insurance strategy directly.

2.1. HISTORICAL VOLATILITY

This estimation method consists of calculating the standard deviation of the daily return stocks. In order to
compute historical volatility we usually use the preceding period with a similar duration to the period we wish to
analyse. This is, nevertheless, used in practice but without any scientific support. If we admit that intermediate
cash-flows do not exist (as in the case of the dividends) we have:
n

S ∑R t
Rt =ln t and R = t =1

St−1 n
we found:

∑ (R )
n
2
t −R
σ= t =1
(5)
n −1
To use the whole sample to compute volatility (this method presupposes the same weighting for all the
observations) does not allow recent information to be enhanced. In the case of the volatility, it can be very
important. It is usual to consider that the more recent data is better for forecasting and also that a larger number
of observations will improve the quality of the estimate. In the case of the volatility, these two rules have to be
faced with some reservation. Thus, very distant data cannot, thwarting the general rule, improve the estimate, and
to introduce a larger observation number can lead to worse results. On the other hand, to consider only the recent
data and ignore historical information would not be a very good solution because historical information is also
useful. Thus, the use of this estimation method of volatility has been made resorting to several weighting rules.
These weighting rules should be specific for each market according to its own characteristics, and without
ignoring the older observations, enhancing the more recent ones. The verification of the limits of this estimation

3
Amin and Ng made a first attempt, without the same success in 1993.

5
method led some authors to propose some variants. Nevertheless, in this article, we use the simplest formulation
of historical volatility.

2.2. IMPLIED VOLATILITY

The first paper published about implied volatility estimation was Latané’s and Rendleman’s (1976).
Mathematically the inversion of Black-Scholes formula is impracticable, that is why computing implied volatility
is non linear. A closed formula that allows for its rapid achievement does not exist, so finding the exact value
implies the use of an iterative search process. To make the method operational, several numeric procedures arise
in literature.
A bisectional method can be used to obtain implied volatility. This method begins with two estimates of implied
volatility: one lower estimate σ L corresponding to an option value of C L , and a higher estimate σ H
corresponding to an option value of C H . The bisectional estimate is given for the linear interpolation between
the two estimates, the low and the high. So it is given for:

σ H −σ L
σ t +1 = σ L + (C m − C L ) (6)
CH − CL

If C m − C (σ t +1 ) ≤ ξ , being ξ the desired degree of accuracy, then σ t +1 is the implied volatility at time t+1.

If Black-Sholes model was correct we should only find a volatility value for each term of an option. However
there are several empirical studies that prove exactly the opposite, which means implied volatility of options with
the same expiry date and different exercise prices is high for out-of-the-money and in-the-money options and low
for at-the-money options. Such a relationship between volatility and different exercises prices exhibits a U shape
that is usually known as the volatility smile effect. The existence of the volatility smile leads implied volatility
values to be systematically correlated with exercise prices. Volatility smile is the formal proof that we should not
assume a constant volatility as the Black-Scholes model does. Several researchers carried out studies on this
subject and have demonstrated that the values that are usually calculated for volatility are closer to real ones
when the prices used to compute volatility are at-the-money. Such a situation is often explained by the fact that
these options are usually the most negotiated and also the ones that reflect fewer errors proceeding from bid-ask
spread or from the fact that prices used are not simultaneous. It is also necessary to avoid the use of options of
different maturities because they reflect different expectations of short and long term volatility. The result is a
“volatility term structure”. All these facts are rightly proved in literature and set out more proof that the Black-
Scholes model is inconsistent with options market reality.
Notwithstanding its limitations, implied volatility is still one of the most widely used forms of Black-Scholes
model. It became particularly important because it captures the market’s general opinion about the assets
volatility. The fact that we get several volatilities for the same asset is usually solved using various weighting
schemes.

2.3. DETERMINISTIC VOLATILITY

Engel’s (1982) ARCH model, was the starting point for the development of a wide set of models with several
applications, namely econometrics, time series and stochastic processes. These models had been widely applied
in statistical modelling of time series.
The ARCH model is, within the family of deterministic volatility models, the most general. When the subject of
analysis is volatility, the autoregressive term refers to the persistence element and the term conditional
heteroskedasticity is used to describe the presumed dependence of current volatility from the level of past
volatility. That is why we say that within these models there is a “stochastic and endogenous parameterisation of
heteroskedasticity” Nicolau (1999). Volatility is expressed through previous observations of the values of squared
returns. That is:

6
y t = xt β + ε t (7)

ε t = σ t + vt
(8)

Q
σ t2 = ω + ∑ α i ε t2−i (9)
i =1

Com σ t2 = E [ε t2 ε t2−1 ] (10)

Where y t is the instantaneous stock return, xt is the exogenous explaining variables vector or bellowing to the
set of information {yt −1 } , β is a fixed parameter vector, vt is a random distribute on that cov(σ t , vt ) = 0
with a standardized normal distribution and Q is the autoregressive order. To guarantee that volatility is non-
negative we assume that ω 〉 0 and α i ≥ 0, ∀i = 1,2,..., Q .

Engle’s (1982) article is a benchmark in this theory because the probability of financial assets returns distribution
being normal is very low. In general, such distributions are leptokurtic. Treating these kinds of distributions was,
for a long time, an obstacle to the progress of the theory. Engle (1982) proposed an explanation that enables the
treatment of the problem: a leptokurtic distribution is due to the fact that the conditional distribution is probably
normal4, but the variance itself is changing through time. This explanation is the starting point to prove that the
transition of a conditional distribution with zero mean and variance σ t2 , to a non-conditional distribution leads to
a leptokurtic distribution. This is justified because joining two normal distributions with equal means and
different variances leads to a fat-tailed distribution, that is, a distribution where the extreme values occurrence
probability is higher than in a normal distribution5.
However, volatility persistence is usually very high, requiring the use of autoregressive models of high orders,
which means that Q parameter is very high. To avoid this problem we do not work with ARCH models but rather
with GARCH (Generalized Autoregressive Conditional Heterocedasticity) models that were developed by
Bollerslev (1986). Besides historic asset returns, the last model uses past observations of volatility itself, which
gives a large contribution to lower the order of autoregressive models. So we can express volatility time
dependence with an inferior number of parameters. In a GARCH model we assume that a single function with the
same random source drives simultaneously to the price of the underlying asset and volatility itself. This model
has been empirically tested and proves that it can explain the assets return volatility process. In a GARCH (P, Q)
conditional variance takes a different expression and it can be represented as follows:
Q P
σ t2 = ω + ∑ α i ε t2−i + ∑ β j σ t2− j (11)
i =1 j =1

Where P represents the volatility autoregressive term. We also assume that ω 〉 0 , α i ≥ 0, ∀i = 1,2,..., Q ,
Q P
β j ≥ 0, ∀j = 1,2,..., P and ∑α i + ∑ β j 〈1 .
i =1 j =1
In this model if P=0 we have an ARCH (Q). If we get

Q P

∑α i + ∑ β j = 1 , a high persistence exists in volatility, which is better explained by an IGARCH (Integrated

i =1 j =1

4
As we shall see later, that hypothesis is not a restrictive one because ARCH models can be tested with other
probability distributions.
5
See Nicolau, João (1999).
7
GARCH)6. In those conditions conditional variance does not exist, which means that the return and the squared
return series follows a process not stationary in covariance.
ARCH models estimate is usually done with maximum likelihood estimation method under the hypothesis that
returns follow a normal distribution. However, the estimation can be made applying t-Student distribution. If we
do so the model takes the name of GARCH-t7.
Other well-known and widely used ARCH model is EGARCH (Exponential GARCH) developed by Nelson
(1991). This model has the advantage, within the aforementioned, of capturing asymmetric effects of downward
and upward trends in the financial markets8. In EGARCH (P,Q) model conditional variance is:

ε t −1 Q ε t −i
( )
Q P
ln σ t2 = w + ∑ γ i + ∑ α + ∑ β j ln σ t2− j (12)
i =1 σ t −1 i =1 σ t −1 j =1
2 2

In this model, we introduce simultaneously ε t −i and its absolute value, then we are able to capture some of the
asymmetry between the stock return and its conditional volatility. Asymmetry is measured by γi .

3. MODELLING THE VOLATILITY OF PSI 20 INDEX

Due to the fact we use three different methods to estimate volatility: the historical, implicit and ARCH, we have
to use two data series. The second estimate uses the daily series of PSI-20 options and the first and third
estimates, the daily series of the PSI-20 index stock return. Since the goal of the analysis is to find a good
volatility forecast of the daily PSI-20 index stock return, it is on this last series that the next analysis relapses.
The PSI 20 series used is the daily data covering the period from 2 January 1993 till the end of September 2001
(2166 observations of daily closing prices). Instantaneous return was computed:

⎛ I ⎞
y t = ln⎜⎜ t ⎟⎟
⎝ I t −1 ⎠ (13)

Where It presents PSI-20 index in moment t.

Graph 2 – PSI-20 Daily Closing Prices Graph 3 – PSI-20 Return

15000
0,08
13000 0,06
0,04
11000 0,02
0
9000
-0,02

7000 -0,04
-0,06
5000 -0,08
-0,1
3000
-0,12

6
Notice that it is usual to find high persistence values for volatility when we use, in estimation, high frequency
observations.
7
Another way to make the ARCH estimation is by ignoring the return distribution and applying the quasi-
maximum likelihood function.
8
In financial markets it is often observed that downward trends are followed by higher volatilities than upward
trends of the same magnitude. Capturing this asymmetric effect can be very important.

8
Periods of high and low volatility have been observed in the PSI 20 prices. Four different periods can be
distinguished, according to the graphs:

- 04.01.93 – 24.08.04: period of average volatility;

- 25.08.94 – 31.12.96: period of low volatility;
- 02.01.97 - 10.04.00: period of high volatility and high return
- 11.04.00 - 30.09.01: period of high volatility and low return
-
Table I: Statistical indicators for the different periods of volatility

average average return(%) daily variance e volatility (%)

04.01.93 - 24.08.94 3 935,16 0,09 0,80993432 14,269002
25.08.94 - 31.12.96 4 282,26 0,03 0,220192597 7,442638281
02.01.97 - 10.04.00 10 052,56 0,12 2,024804998 22,57483654
11.04.00 - 30.09.01 10 347,91 - 0,16 1,024191646 19,05778978
04.01.93 - 30.09.01 7 401,92 0,04 1,149141105 17,54927553

During two first periods in table I, the Portuguese Stock Exchange took off. The golden period of our capital
market is the one between 02.01.97 and 10.04.00, where high returns and high volatility have been observed. The
main factors that have contributed to this golden period were the fiscal incentives, and the profitable perspectives
created by the privatisation of a large number of state corporations. The absence of these effects, during the
period between 11.04.00 and 30.09.01, together with the general slowing down in the stock exchanges,
throughout the world, explain the co-existence of high volatility with low return during that period.
Table II: amplitude of the changes in the PSI 20 index
02.01.97 - 10.04.00 11.04.00 - 30.09.01
Maximum 14822,59 12597,69
Minimum 5152,34 6488,01
Difference 9670,25 6109,68

The maximum and the minimum values presented in table II, for a period of high return and for a period of low
return, can be taken as evidence of the leverage effect, which means that volatility is higher when prices are
falling than when they are increasing.
Analysing descriptive statistics of PSI-20 returns:

Table III: descriptive statistics of PSI-20 returns

Graph 4 – Histogram of PSI-20 returns
600
Series: RENDIBILIDADE
Sample 1/04/1993 9/28/2001
500
Observations 2166

400 Mean 0.000412

Median 0.000376
Maximum 0.069413
300
Minimum -0.095898
Std. Dev. 0.011058
200 Skewness -0.682227
Kurtosis 10.76585
100
Jarque-Bera 5610.850
Probability 0.000000
0
-0.100 -0.075 -0.050 -0.025 0.000 0.025 0.050

9
Notice that PSI-20 index return time series has a negative skew and high kurtosis value (leptokurtic) that suggests
the series distribution its not a normal one, namely it has fatter tails. This result is confirmed by Jarque-Bera
statistic. Histogram analysis confirmed these conclusions.
Given the difficulty in making a complete description of a stochastic process of a time series, it is usual to recover
to autocorrelation function. This particular case provides a description of a time dependent pattern that is
particularly important to modelling the variable whose stochastic process we are studying.

Table IV – Autocorrelation and partial autocorrelation functions of return and squared return
Order Return Square return
ACF PACF Q-Stat P-value ACF PACF Q-Stat P-value
1 0.181 0.181 70.724 0.000 0.233 0.233 118.11 0.000
2 0.042 0.009 74.507 0.000 0.115 0.064 146.73 0.000
3 0.018 0.009 75.219 0.000 0.147 0.113 193.50 0.000
4 0.051 0.047 80.849 0.000 0.102 0.04 216.32 0.000
5 0.002 -0.016 80.859 0.000 0.061 0.013 224.43 0.000
10 0.040 0.039 89.986 0.000 0.077 -0.013 436.89 0.000
15 0.056 0.036 105.72 0.000 0.090 0.034 489.14 0.000
20 0.029 0.034 116.39 0.000 0.031 -0.016 539.34 0.000

A high autocorrelation of squared returns is already expected. This means that high values of time series are
followed by another high value. This statement could be the first indication that the stochastic process followed
by this series could be explained with resort to ARCH family models.
The whole analysis emphasizes the non-linear structure of the series. We could conclude that the non-conditional
distribution is slightly asymmetric and leptokurtic. As we have already pointed out this distribution can be related
to a conditional distribution (that can be normal) but where variance is changing through time. Testing that
hypothesis is testing the hypothesis of PSI-20 stock index following an ARCH process.

3.1. HISTORICAL VOLATILITY

In order to compute the daily historical volatility, for comparability reasons, we choose to compute the standard
deviation of the stock return from the previous month. Notice that the options used to compute the implicit
volatility refer generally to periods inferior to 30 days. As the goal of the present article is to compare the
analyses, it does not make sense to work with historical volatilities of inferior periods.
Just as expected, given circumstances, the historical volatility contemplates, with some delay, which is verified in
the finance market.

10
Graph 5 - Historical volatility versus standard deviation of the stock return

50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
19-03-1999

19-06-1999

19-09-1999

19-12-1999

19-03-2000

19-06-2000

19-09-2000

19-12-2000

19-03-2001

19-06-2001

19-09-2001
Historical volatility Stand.deviation

3.2. IMPLIED VOLATILITY

A second attempt of modelling PSI-20 stock index volatility undertakes implied volatility. Investigating implied
volatility faces several limitations. Besides the usual ones related in empirical studies carried out in foreign
markets, for instance the smile effect and the “volatility term structure”, we have to face additional difficulties in
the Portuguese market.
In Portugal work implied volatility of PSI-20 index implies the use of PSI-20 options. The underlying asset of the
options on the PSI 20 is a futures contract on the same index, which means that the volatility of the spot index
itself cannot be extracted directly from these options. This is a problem, bearing in mind the results of Kawaller
(1990) according to which the volatility of the S&P 500 futures is higher than the volatility of the spot. Another
problem is that the option on the PSI-20 futures contract has only existed since 19 March 1999. So the analysis
concerns only the period from 19 March 1999 to the end of September 2001.
The market for these options has not been a very active one. During 2000 the number of days without
transactions on these options has been very significant. Only after May 2001 has the number of transactions been
increasingly intensified. Since the month of June 2001 several contracts have been negotiated practically every
day. This five-month period is, however, a short one for a thirty-month period analysis.
The present analysis only concerns call options because the PSI-20 put options had very low negotiation volumes,
of just about 50% of the verified with the call options.
Most of the options contracts that have been traded are of very short maturity, usually less than one month. This
tendency has been emphasized throughout the whole analysed period. In 2001 there were only 9 days with
transactions of options whose maturity was higher than 30 days. A significant number of these options has been
out of money, during the greater part of that period, according to Brenner and Subrahmanyam’s (1988) definition.
The bisectional method has been used to calculate implied volatility, using an exactitude degree of 0,01%. In
order to eliminate problems of term structure of volatility, only options with expiry date before 30 days have been
considered. On the days in which options with different exercise prices have been traded, the corresponding
volume of transactions weighted the computed volatilities.
The values obtained for the implied volatility for the period under analysis are presented in Graph 6.

11
 Graph 7 - Relationship between implied
Graph 6 – Implied volatility of PSI-20 index volatility and standard deviation

100%
120%
90%
80% 100%
70%
80%
60%
50% Implied Volatility
60%
40% Stand.Deviation

30% 40%
20%
20%
10%
0% 0%
1 8-0 3- 19 99
1 8-0 5- 19 99
1 8-0 7- 19 99
1 8-0 9- 19 99
1 8-1 1- 19 99
1 8-0 1- 20 00
1 8-0 3- 20 00
1 8-0 5- 20 00
1 8-0 7- 20 00

1 8-0 9- 20 00
1 8-1 1- 20 00
1 8-0 1- 20 01
1 8-0 3- 20 01
1 8-0 5- 20 01
1 8-0 7- 20 01
1 8-0 9- 20 01

19-03-1999

19-06-1999

19-09-1999

19-12-1999

19-03-2000

19-06-2000

19-09-2000

19-12-2000

19-03-2001

19-06-2001

19-09-2001
In the previous graph, , the discontinuity in the implied volatility observations is visible.
Graph 7 was constructed with the aim of comparing the tendencies of the implicit volatility with the standard
deviation of PSI-20 index return of the study period. The analysis of this graph shows that, besides being related,
implied volatility is clearly higher that real volatility.
In order to present this comparative graph, since not everyday were there transactions and consequently prices in
the options market, for the days without transactions, the value of the implicit volatility previously observed was
considered. This analysis is, however, very limitative since there were only transactions in the portuguese options
market in 234 of the 630 days that the market was open.
A small detail analysis still allows one to verify the following results:

Table V - Medium volatility and medium implicit volatility in the sample

All period Mondays Tuesday Wednesday Thursday Friday
Including 11 Standard deviation 19,28% 18,55% 20,30% 17,18% 18,68% 21,13%
September Implied Vol.Call 23,82% 23,53% 24,41% 23,27% 24,86% 22,22%
Excluing 11 Standard deviation 18,67% 18,32% 18,88% 16,59% 18,71% 20,08%
September Implied Vol.Call 23,53% 23,39% 23,99% 23,16% 24,93% 22,00%
Observations Sample 629 125 125 127 126 126
All sample Options 234 50 48 79 46 43
days without transactions 395 75 77 48 80 83
% days without option transactions 62,80% 60,00% 61,60% 37,80% 63,49% 65,87%
Note: It is only anualised values

This picture enables an additional comparative analysis to be made between the standard deviation of PSI-20
index return and the implicit volatility. It still allows for some conclusions concerning " weekend " effects.
It is verified that a significant difference exists between the standard deviation and implicit volatility, with the
added difficulty that the implicit volatility does not have the same tendency of the week day observations as it is
observed in the spot market. It is also verified that the " weekend " effects that are quite common in financial
series is not present.

3.3. DETERMINISTIC VOLATILITY

A first attempt of modelling deterministic volatility with resort to ARCH models leads to the estimations of the
following models:

y t = ϑ0 + ϑ1 AR(1) + ε t (mean) (14)

12
σ t2 = ω + α 1ε t2−1 + β 1σ t2−1 (GARCH(1,1)) (15)

ε t −1 ε
σ t2 = ω + α 1 + γ 1 t2−1 + β 1 ln σ t2−1 (EGARCH(1,1)) (16)
σ t −1
2
σ t −1

If we analyse ACF and PACF of return and square return we can conclude that the ARCH model is not the most
appropriate model to estimate PSI-20 stock index volatility. Therefore we chose to estimate GARCH (1,1) and
EGARCH (1,1). EGARCH arise because of our first conclusion that we may be in the presence of leverage effect.
If that is correct, the use of the EGARCH model could be an advantage because it better captures the asymmetry
of the series. In order to evaluate the adjustment quality we also estimated the GARCH (1,2) and EGARCH (1,2)
models.

TableVI – Estimated models

Parameters GARCH (1,1) EGARCH (1,1) GARCH (1,2) EGARCH (1,2)
Average
Constant -0.000343 (0.001) -0.00079 (0.001) -0.000352 (0.001) -0.000800 (0.001)
AR(1) 0.127477(0.0418) 0.134444 (0.042) 0.126841 (0.043) 0.143243 (0.042)
Variance
Constant 0.000010 (0.000) -0.899119 (0.287) 0.0000096(0.000) -1.047872 (0.341)

ε t2−1 0.146751 (0.034) 0.155082 (0.060)

σ t2−1 0.787252 (0.052) 0.794891 (0.058)

ε t2− 2 -0.012802 (0.064)

ε t −1 0.257096 (0.053) 0.255591(0.1037)

σ t2−1
ε t −1 -0.109130 (0.028) -0.082316 (0.056)

σ t2−1

ε t −2 0.922143 (0.003) 0.016108 (0.108)

σ t2− 2
ε t −2 -0.042068 (0.053)

σ t2− 2

ln σ t2−1 0.906819 (0.035)

Note: Standard deviation is shown between brackets.

All the parameters, for GARCH models, are significant at a 10% level, however model GARCH(1,1) has the
better results. EGARCH and specially EGARCH(1,2) has problems in the significance of parameters. Coefficient
ε t −1
in EGARCH (1,1) and EGARCH (1,2) model has negative but not significant values, which lead to the
σ t2−1
conclusion that leverage effect in the PSI-20 index for the analysed period is not significant.

13
It is important to verify the presence of heteroskedasticity and temporal autocorrelation in standardized residuals.
Durbin-Watson test allows the conclusion that, in all the tested models, we can eliminate that hypothesis9. Q
statistics of Ljung-Box has proved the previous conclusions. It is shown than that estimated GARCH models are a
reasonable approach of the generating process of PSI-20 index.
Table VII -Quality evaluation of adjusted models
GARCH (1,1) GARCH (1,2)
Information Akaike -6,088168 -6.085115
criterion
Schwarz -6,053439 -6,043441
Regression standard error 0,012092 0,012101
Maximum Log Likelihood 1962,346 1962,365
Volatility persistence (α+β) 0,934 0,937
ARCH-LM 0,8491 0,9597
We can verify that the most adequate model is GARCH (1,1) considering the significance of its parameters and
the minimum differences in the parameters when compared to the other model.
To evaluate the forecast ability of the models, the forecasted value of volatility one-step-ahead was computed
within the sample.
Table VIII – Forecast ability one-step-ahead within the sample
GARCH (1,1) GARCH (1,2)
Root mean squared error 0,012045 0,012045
Mean abs. percentage error 120,4808 120,4013

The forecast ability of these models is usually verified by the analysis of the tests presented by the previous table.
A good forecast model is the one that minimizes loss functions. That is why we should say that, although it is
similar, we can distinguish GARCH (1,2) model. However, there is a minimum difference for the tested models.
So taking into account the previous results, we should consider GARCH (1,1) as the better model to explain and
forecast the volatility of PSI-20 stock index.
Graph 8 – GARCH volatility forecasts one-step-ahead within and out of the sample

50%

45%

40%

35%

30%
Desv. Padrão
Standard deviation
25%
Garch Volatility
Volatilidade GARCH
20% (within the sample)
(dentro da amostra)

15% Garch Volatility

Volatilidade GARCH
(out of
(fora dathe sample)
amostra)
10%

5%

0%
19-03-1999

19-05-1999

19-07-1999

19-09-1999

19-11-1999

19-01-2000

19-03-2000

19-05-2000

19-07-2000

19-09-2000

19-11-2000

19-01-2001

19-03-2001

19-05-2001

19-07-2001

19-09-2001

9
Durbin-Watson statistics show values of 1,98, 1,99, 1,98 and 2,01 respectively to GARCH (1,1), EGARCH
(1,1), GARCH (1,2) and EGARCH (1,2).
14
In graph 8, the volatility forecast is presented, according to the model GARCH (1,1), one-step-ahead within and
out of the sample.
They are compared here with the standard deviation of the PSI-20 index return observed during the analysed
period. The simple graphic analysis allows one to verify that the results within the sample are a better approach to
the standard deviation, this result was, in fact, predictable.
However, although it is observed that the GARCH volatility forecasts within the sample are better, it is verified
that both forecasts are very close.
Nevertheless, in the next point of the present article, the values of the GARCH volatility forecast that are used are
the ones obtained one-step-ahead out of the sample, since this is the only way to guarantee the comparability with
the historical and implicit series.

4. VOLATILITY AND PORTFOLIO INSURANCE

In the empirical simulation of the portfolio insurance strategy it was considered that the temporal horizon, like the
one that had already been considered in the forecast of volatility, was the period of April 19th 1999 to the end of
September 2001.
The risk-free interest rate considered in the applications is LISBOR (12 months). The hedging portfolio will be a
portfolio with identical composition to the one of PSI 20 index. The floor considered was 90% of the starting
value of the underlying stock at the starting date of the strategy, that is to say 9168,363. The choice of a floor less
than 100% implies the safety decrease but a better performance of the portfolio if the market rises.
As it is a dynamic strategy, it is necessary to rebalance the portfolio with some periodicity. The most frequent
way to do it is to rebalance in fixed periods of time (weekly, monthly, etc) and to rebalance whenever a certain
variable loses more than a certain specified value. The second method has the advantage of avoiding unnecessary
revisions and/or out of the timing. In the present study, because we intend to compare results, for there is a
coincidence in the revisions of the strategy, we choose to rebalance the portfolio whenever the index varies more
than 300 points.
The strategy allows the following results to be obtained:

Graph 9 – Portfolio insurance with historical volatility Graph 10 – Portfolio insurance with implied volatility

16000,00 16000,00
14000,00 14000,00
12000,00 12000,00
10000,00 10000,00
8000,00 8000,00
6000,00 6000,00
19-03-1999

19-06-1999

19-09-1999

19-12-1999

19-03-2000

19-06-2000

19-09-2000

19-12-2000

19-03-2001

19-06-2001

19-09-2001
19-03-1999

19-06-1999

19-09-1999

19-12-1999

19-03-2000

19-06-2000

19-09-2000

19-12-2000

19-03-2001

19-06-2001

19-09-2001

Portfolio S ricklessApl. Floor Portfolio S RisklessApl. Floor

Graph 11 – Portfolio insurance with GARCH volatility

15
 16000,00
14000,00
12000,00
10000,00
8000,00
6000,00
23-03-1999

23-06-1999

23-09-1999

23-12-1999

23-03-2000

23-06-2000

23-09-2000

23-12-2000

23-03-2001

23-06-2001

23-09-2001
Portfolio S RisklessApl Floor

The first rehearsals enhanced the superiority of the use of the historical and implicit volatility in the calculations
of the portfolio insurance strategy, despite being the ones that stand further back from the standard deviation.
Because it is a period of slump in the markets and because the implied volatility overvalues the volatility, there
was a need to verify whether the results obtained were no more than the verification of what was initially said:
over-evaluating volatility overvalues the put option leading to a smaller investment in the risky asset that benefits
the portfolio in the case of falling markets and that prejudices it in the case of an upward trend in the market. So
a small analysis was carried out for the sub-period of 19 March 1999 to 03 March 2000, a period of rising
quotations. The results obtained are:

Graph 12 – Portfolio insurance with historical volatility Graph 13 – Portfolio insurance with implied volatility

17000,00
17000,00

15000,00 15000,00
13000,00
13000,00
11000,00
11000,00
9000,00
19-03-1999

19-04-1999
19-05-1999
19-06-1999
19-07-1999

19-08-1999
19-09-1999
19-10-1999
19-11-1999
19-12-1999
19-01-2000
19-02-2000
9000,00
19-03-1999

19-04-1999

19-05-1999

19-06-1999

19-07-1999

19-08-1999

19-09-1999

19-10-1999

19-11-1999

19-12-1999

19-01-2000

19-02-2000

Portfolio S Portfolio S

Graph 14 – Portfolio insurance with GARCH volatility

17000,00
15000,00
13000,00
11000,00
9000,00
23-03-1999
23-04-1999
23-05-1999
23-06-1999
23-07-1999
23-08-1999
23-09-1999
23-10-1999
23-11-1999
23-12-1999
23-01-2000
23-02-2000

Portfolio S

Once again it is verified that the results obtained with the use of the historical and implied volatility are superior.
Analysing the error statistics defined by Gallais-Hammono and Berthon obtains:

Table IX - Gallais-Hammono and Berthon error statistics

16
 P.I. with historic vol. P.I. with implied vol. P.I. with GARCH vol.
19.03.99/28.09.01 -2,18% -2,57% -5,4%
19.03.99/02.03.00 -0,37% -0,26% -1,02%

The following statistics are still obtained:

Table X – Statistics for Portfolio insurance strategies
Mean Standard deviation
P.I. with historic volatility 11100,24 861,645
P.I. with implied volatility 11108,15 886,910
P.I. with GARCH volatility 10959,89 1297,047

These results suggest that despite GARCH volatility being the one that approximates more, and the implicit
volatility the one that stands further back from the PSI-20 index return standard deviation, it is with the use of
historical and implicit volatilities that the best performances of the strategy is obtained.

5. CONCLUSION

The results of the present research lead to the conclusion that the PSI 20 series is not a stationary one. Under
these circumstances, the Black and Scholes formula is not the most adequate to evaluate options on the PSI-20
futures, which is clearly proved by the difficulties in the attempt at modelling implied volatility. Modelling
volatility with ARCH models is one among several alternatives to Black and Scholes model. Within the ARCH
family, our results revealed that the GARCH (1,1) model is the most adequate for modelling the volatility of the
series under analysis. This result is in accordance with similar results obtained in other markets, such as the S&P
500 options. Nevertheless, these results concerning volatility forecast, we find in an empirical application of
portfolio insurance, that implied and historical volatility supplies the best results for the strategy. A careful
analysis of the Vega of the option (that measures the volatility sensibility of the option price) suggests that
rebalancing, and namely using GARCH volatility, was not made at the correct time, taking losses in the portfolio
value that we were unable to recover later on.

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