In Part two of our series on Structured Products, let’s learn about Constant Proportion Portfolio Insurance.
These classes are all based on the book Trading and Pricing Financial Derivatives, available on Amazon at this link. https://amzn.to/2WIoAL0
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What is Constant Proportion Portfolio Insurance (CPPI)?
Constant Proportion Portfolio Insurance (CPPI) is a type of portfolio insurance in which the investor sets a floor on the dollar value of their portfolio, then structures asset allocation around that decision. The two asset classes used in CPPI are a risky asset (usually equities or mutual funds) and a conservative asset of either cash, equivalents or treasury bonds. The percentage allocated to each depends on the “cushion” value, defined as current portfolio value minus floor value, and a multiplier coefficient, where a higher number denotes a more aggressive strategy.
Understanding Constant Proportion Portfolio Insurance (CPPI)
Constant Proportion Portfolio Insurance (CPPI) allows an investor to maintain exposure to the upside potential of a risky asset while providing a capital guarantee against downside risk. The outcome of the CPPI strategy is somewhat similar to that of buying a call option, but does not use option contracts. Thus, CPPI is sometimes referred to as a convex strategy, as opposed to a “concave strategy” like constant mix. Financial institutions sell CPPI products on a variety of risky assets, including equities and credit default swaps.
A CPPI fund is a fund where the manager allocates dynamically and regularly exposure to risky assets (underlying such as equities or stock indices) and non-risky assets (bonds, money market funds) in order to ensure the preservation of invested capital.
To achieve his goal, the manager defines the “cushion” or the percentage of the fund’s assets that may be put at risk without any effect on the level of protection.
The “cushion” is estimated by the difference between the initial value of the product and the present value minimum necessary to provide the capital guarantee at maturity.
Using quantitative models, the manager will then compute a level of indexing (or multiplier) to apply to the “cushion” to get the portfolio’s exposure to the risky underlying.
The adjustment of indexing level will depend on the dynamic changes of the risky underlying.
The more risky assets perform, the stronger indexing level will be, and the more the manager will increase exposure to risky assets.
On the other hand, the less risky assets perform, the weaker indexing level will be, and the more the manager will decrease exposure to risky assets
The indexing level may exceed 100% in case of initial good performances of risky assets, and generate a better overall return for the fund.
Risk of monetization (the level of exposure to the risky assets becomes zero) if the risky assets underperform at launch