why loss is unlimited for selling insurance, for example constant mix, if selling insurance, they get premium but they will pay you the amount in the insurance contract at most say 1 million for life insurance, why textbook says loss is unlimited?
CM -
Buys when market goes down, sells when market goes up…(contrarian)
Suppose CM is Equity/TA = 0.6…you have 60 equity, 40 cash
- market goes down by 20% so value of equity = 60 * (1-0.20) = 48, cash = 40, Total assets = 48+40 = 88
now equity represent 48 / 88 = 54.54% so you bur more equity
(48+x) / 88 = 0.60…so X = 4.8…no Total assets contain equity = 52.8 & cash = 40-4.8= 35.2
As market goes down & down, you keeping on buying equity using cash…eventually comes a stage you deplete your entire portfolio…
loss is unlimited because there is no floor in CM. IMO, premium could also be used for buying in a down trending market?
Hi, understand, but half of my question is why sell insurance may have unlimited loss, there is no floor for insurance? the book says constant mix is like selling insurance.
I never see a insurance contract got unlimited loss, so why the textbook says unlimited?
I think that constant mix has a payoff like a short put. As such would have a max loss of 100% of portfolio value (as there is no floor and you keep rebalancing back into the declining equity until you finally are down to $0.01 in cash). I guess it could be unlimited if you borrow to rebalance once you get to the 0.01.
loss is not unlimited . It has a finite limit , whatever you started with.
To a short , the potential loss can be unlimited .
But CM is not a short strategy.
For a long only equity portfolio with a cash balance , you can only lose the portfolio .
I think they mean it is the context of a liquidity provider . When the market is betting on a trend , it can be very risky to be a contrarian which is what the CM is.
On the other hand a CPPI is a liquidity absorber , who takes up any risk they can get