Constant Proportion Portfolio Insurance: Statistical Properties and Practical Implications

Constant Proportion Portfolio Insurance (CPPI) is a dynamic portfolio management strategy that is currently of popular interest in both industry and academic research. The CPPI methodology is designed to guarantee, to the buyer, a minimum payoff at maturity using a portfolio comprised only of one risky asset and one riskless asset. The goal is to allow an amount of participation in capital markets while removing downside risk. However, in the presence of realistic market assumptions risk to the seller exists in the form of gap risk. This gap risk accounts for the inability tomeet the guarantee at maturity. There are many factors which contribute to the gap risk, including asset price behaviour and trading frequency. The effect of these factors are investigated in this paper within a discrete time framework. The results show that when considering realistic levels of volatility the CPPI does not perform well in comparison to a riskless investment and a gapless (buyand-hold) portfolio, respectively. CPPI returns are highly skewed and, in certain cases, fat-tailed. From the perspective of the buyer, the CCPI’s higher expected return is based solely on the small chance of extremely large returns. In the majority of the cases, however, the CPPI yields a lower return than gapless and even riskless portfolios. Choosing an underlying with high volatility is even more hazardous since even the expected values are lower than that of the gapless alternative. These results are evenmore pronounced with the introduction ofmanagement fees where investors almost always can expect a lower return than from a corresponding buyand-hold portfolio and typically fall substantially short of a riskfree investment. From the perspective of the issuer, a monthly rebalancing frequency is shown to be adequate to reduce the majority of the risk, while retaining a good payoff even when considering transaction costs.