t information to market participants, and this information will not be conveyed if the real security is replaced by synthetic trading strategies. In particular the replacement of a real security by synthetic strategies may in itself cause enough uncertainty about the price volatility of the underlying security that the real security is no longer redundant.
Portfolio insurance provides a good example of the difference between a synthetic security and a real security. One form of portfolio insurance uses a trading strategy in risk free securities ("cash") and index futures to synthesize a European put on the underlying portfolio. If a put was traded on a securities market, then the price of the put would reveal important information about the desire of people to sell stock consequent to adverse future price moves (Throughout this paper, "stock" is often used interchangeably with "stock index" to represent a portfolio of risky assets). For example, if everyone in the economy would like to get out of stocks before the price falls by more than 25%, then the price of such a put option would be very high. If only a few holders of stocks desired such protection then the put option's market price would be low. The put's price thus reveals information now about the fraction of people with plans to get out of (or into) stocks in the future. The put's price reveals the extent to which the strategies of people can cohere in the future. By showing people the true cost of their plans it may discourage people from attempting to purchase too much insurance in exactly those circumstances when the dynamic hedging strategy would raise stock price volatility (The cost of the strategy is the potential upside gains that are foregone to protect against downside losses. If the stock volatility is high then this cost will be high. We will argue below that the volatility will be higher the larger is the number of investors using portfolio insurance s...