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 offering a capital guarantee against downside risk. The result of the CPPI strategy is somewhat similar to buying a call option, but it does not use option contracts. Therefore, CPPI is sometimes referred to as a convex strategy, as opposed to a "concave strategy" as a constant mix. Financial institutions sell CPPI products on a variety of risk assets, including stocks and credit default swaps.
CPPI is a strategy to combine the advantage of exposure to the equity market with investments in a conservative financial instrument. This is done by assigning a specifically calculated investment percentage to a risk account.
A multiplier is used to determine the amount of risk an investor is willing to take.
Investors can rebalance their positions on a monthly or quarterly basis.
How Constant Proportion Portfolio Insurance (CPPI) Works
The investor will make an initial investment in the risk asset equal to the value of: (Multiplier) x (value of the cushion in dollars) and will invest the rest in the conservative asset. The value of the multiplier is based on the investor's risk profile and is obtained by first asking what the maximum loss in a day of the risk investment could be. The multiplier will be the inverse of that percentage. As the value of the portfolio changes over time, the investor will rebalance according to the same strategy.
CPPI consists of two accounts: a risk account and a security account. As their names indicate, both accounts serve specific purposes in an individual's overall investment strategy. The risk account is leveraged with futures holdings to hedge against the downside of significant exposure to equities. The funds are dynamically transferred between the two accounts based on the economic environment.