An insurance approach to the pricing of downside risk in Argentinean stocks

Abstract

Downside risk stands for the risk associated with realized returns being below expected returns. When focusing on stocks, even though the drift should and tends to be positive, there are periods of stress where investors lose money. The return dynamics of Argentina's main stock index, the Mer.Val., show a high level of volatility, signaling a higher degree of downside risk. To hedge against that specific risk, investors could buy put options. However, the Argentinean capital markets lacks variety of hedging contracts. The basic availability of put options depends on the possibility of short selling the underlying security, i.e. transfer risk to a third party, something not properly developed in the domestic market. In this paper we adopt a different approach to solve the issue, more inclined towards self-insurance. We aim to calculate the minimum capital a put option seller must hold as collateral, to provide insurance to the market, and hence derive the price of the instrument as the required value that must be charged for that purpose. In that way, we provide a downside-risk hedge against adverse stock index price movements.