Paper
Journal of Derivatives & Hedge Funds (2008) 14, 31–41. doi:10.1057/jdhf.2008.4
An option pricing approach to the estimation of downside risk: A European cross-country study
Practical applications The results of this study provide some useful information to investors in European markets in general, as well as to financial institutions such as investment bankers who supply financial products to investors. First, an assessment was made of the cost of downside protection in the four major European markets, based on the characteristics and historical track records of each market. Secondly, an examination was made of the time diversification effects in these markets, by examining the changes in the cost of downside protection as the investment horizon is increased from one year through to 20 years. These will serve as useful benchmarks for investors who wish to gauge the cost of insuring the downside risks in these markets and to financial institutions who create and offer investment products combined with forms of capital guarantees in these markets.
Lakshman Alles1
Correspondence: Lakshman Alles, Department of Banking and Finance, Curtin University of Technology, GPO Box U1987, Perth 6001, Australia. Tel: +61 89266 7811; Fax: +61 89266 3026; E-mail: Lakshman.Alles@cbs.curtin.edu.au
1Lakshman Alles is an associate professor in the Department of Finance and Banking at Curtin University of Technology, Perth, Australia.
Received 31 January 2008; Revised 31 January 2008.
Abstract
The purpose of this paper is to undertake a comparative study of the costs of downside protection for investors in the four major European stock markets: UK, Germany, France and Italy, and to investigate the time diversification effects in these markets by examining the variation of this cost as the investment horizon is extended. The cost of downside protection and time diversification effects are investigated by examining the properties of a protective put strategy and a capital protected equity participation strategy in each country's stock market over investment horizons ranging from 1 to 20 years. Long-horizon investment outcomes are generated using a bootstrapping technique. Results indicate that the cost of downside protection differs from one country to another, but there is a common pattern of the cost decreasing as the investment horizon lengthens. In overall terms, the pattern of decreasing protection costs at longer investment horizons is consistent with the notion of the time diversification benefits of investment risk.
Keywords:
downside risk, European stock markets, protective put, time diversification
