Portfolio insurance sells more stock as price falls, creating mechanical downward supply.

Evidence

Apart from in one feature to be discussed below, Gennotte and Leland’s is a “rational-expectations” model: it posits investors who have a correct understanding of the price dynamics presumed in the model. The model is of the determination by supply and demand of the price, p°, of a single risky asset, which can be “interpreted as the stock market portfolio” (Gennotte and Leland 1990, p. 1006). Part of the demand for the asset comes from “uninformed investors … who observe only p0” in other words, whose only source of information about the future price of the asset is inference from its current observed price (Gennotte and Leland 1990, p. 1002). Part of the supply of the asset results from the activities of portfolio insurers, who sell increased quantities of it as its price falls. That supply is it(po), a deterministic, decreasing function of p°. — Donald MacKenzie, An Engine, Not a Camera, 867

Categorization

• DEFINE: Defines the Gennotte-Leland model structure: uninformed investors infer from price alone while portfolio insurers sell deterministically as price falls.
• XREF: The ‘uninformed investors who observe only price’ mechanism connects to information-cascade and signaling literatures the reader knows. — connects to: The log-normal assumption may have been self-undermining through portfolio insurance. — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 191; Widely adopted portfolio insurance would amplify market price movements — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 809; Portfolio insurance trades could double NYSE volume on a 3 percent drop — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 811 (+7 more)

Broader Connections

• Portfolio insurance designed to limit losses can amplify market volatility. #expands (0.85) — Shapiro, Susan P., The Social Control of Impersonal Trust, 144
• Derivatives inverted from insurance into engines that increase volatility exposure. #exemplifies (0.80) — Aris Komporozos-Athanasiou, Speculative Communities, 91
• Unknown size of scheduled portfolio sales, not the sales themselves, caused market shock. #qualifies (0.75) — Donald MacKenzie, An Engine, Not a Camera, 883
• Rumors during the 1987 crash exaggerated portfolio insurance trade size three to fourfold #qualifies (0.70) — Donald MacKenzie, An Engine, Not a Camera, 874
• People are risk-averse in gains but risk-seeking in losses #complicates (0.70) — John T. Jost and Jim Sidanius, Political Psychology, 2406