Constant proportion portfolio insurance

From Wikipedia, the free encyclopedia

Constant proportion portfolio insurance (CPPI) is a capital guarantee derivative security that embeds a dynamic trading strategy in order to provide participation to the performance of a certain underlying. See also dynamic asset allocation.

In order to be able to guarantee the capital invested, the option writer (option seller) needs to buy a zero coupon bond and use the proceeds to get the exposure he wants. While in the case of a bond+call case, the client would only get the remaining proceeds (or initial cushion) invested in an option, bought once and for all, the CPPI provides leverage through a multiplier. For example, say an investor has a $100 portfolio, a floor of $90 (price of the bond to guarantee his $100 at maturity) and a multiple of 5. Then on day 1, the writer will allocate (5 * ($100 - $90)) = $50 to the risky asset and the remaining $50 to the riskless asset (the bond). The exposure will be revised as the portfolio value changes, i.e. when the risky asset performs and with leverage multiplies by 5 the performance (or vice versa). Same with the bond. These rules are predefined and agreed once and for all during the life of the product.

1 Some definitions
2 Dynamic trading strategy
3 References
- 3.1 Articles
- 3.2 Internet

[edit] Some definitions

Bond floor

Being a capital guarantee product, the CPPI embeds a bond. The bond floor is the value below which the CPPI value should never fall in order to be able to ensure the payment of all future due cash flows (including notional guarantee at maturity)

Multiplier

Unlike a regular bond + call strategy which only allocates the remaining dollar amount on top of the bond value (say the bond to pay 100 is worth 80, the remaining cash value is 20), the CPPI leverages the cash amount. The multiplier is usually 4 or 5, meaning you do not invest 80 in the bond and 20 in the equity, rather m*(100-bond) in the equity and the remainder in the zero coupon bond.

Namely the measure of relative balance of the equity part over the CPPI value : equity/CPPI. Theoretically, this should equal 1/multiplier.

Trading rules

The CPPI being a dynamic trading strategy, on certain anniversary dates (or depending on the liquidity some trading days, say quarterly for a hedge fund), the weights are rebalanced so as to ensure perfect matching of the multiplier rules and/or making sure the product still guarantees the notional at maturity. This last rule is set up so as to maintain the gap between two barriers, the releverage and deleverage triggers.

[edit] Dynamic trading strategy

Rules

If the gap remains between an upper and a lower trigger bands (resp. releverage and deleverage triggers), the strategy does not trade. It effectively reduces transaction costs, but the drawback is that whenever a trade event to reallocate the weights to the theoretical values happen, the prices have either shifted quite a bit high or low, resulting in the CPPI effectively buying (due to releverage) high, and selling low.

Risks

The crash risk is the main concern of CPPI writer, in that a sudden drop in the risky underlying might drag the overall CPPI value below the actual value of the floor needed to guarantee the capital at maturity. It results in an impossibility to shift assets from the risky one to the bond, hence leading the structure to a state where it is impossible to guarantee the money. This feature being ensured by contract with the buyer, the writer has to put up money of his own to cover for the difference. Some banks hedge this risk with CDS, but it is worth noting that a drop in the risky asset does not always mean the CDS will be triggered, hence this is not a perfect hedge.

[edit] References

[edit] Articles

Fisher Black, Lecture Notes #6.
Pricing of equity linked life insurance policies with an asset value guarantee (Michael Brennan, Eduardo Schwartz, 1976).
Constant Proportion Portfolio Insurance: Volatility and the Soft-Floor strategy(1988), Goldman Sachs Research.
Constant proportion portfolio insurance and the synthetic put option : a comparison, in Institutional Investor focus on Investment Management, Black, F., & Rouhani, R. (1989).
Expected performance and risk of various Portfolio insurance strategies. Boulier and Kanniganti.
Portfolio Insurance Strategies : OBPI versus CPPI. Philippe BERTRAND, Jean-luc PRIGENT - 2002. [1]
Portfolio Insurance: the extreme value approach to the CPPI method, Bertrand.[2]