By Darren Pain of the Bank's Foreign Exchange Division and Jonathan Rand of the Bank's Sterling Markets Division.
The aim of this article is to describe how portfolio insurance works, the main strategies employed and how these have evolved over recent years, and the possible links between their use and financial market stability. The key benefit of portfolio insurance is that it enables financial risk to be distributed among those agents most willing to absorb it. The downside is that it can possibly create conditions for greater fragility in financial markets and leaves issuers of portfolio insurance exposed to potential unexpectedly high losses. It seems unlikely that portfolio insurance-related investments contributed significantly to the financial market volatility that began in Summer 2007. Nonetheless, it is important to keep alert to situations when portfolio insurance could potentially work to amplify financial market instability.