Constant Portfolio Proportion Insurance: An Overview

Constant portfolio proportion insurance (CPPI) is a popular risk management strategy used to protect portfolio returns against market downturns. In this investment strategy, a portfolio is divided into two components: a risky asset and a risk-free asset. The aim is to protect the value of the portfolio by constantly rebalancing the two components. The strategy, which is popular among institutional investors and wealthy individuals, ensures that investments remain safe and secure even when the market is volatile.

CPPI Principles

There are two key principles that underpin the CPPI strategy:

1. Protecting the principal investment: The primary objective of CPPI is to protect the initial principal investment from losses. This is achieved by allocating a portion of the portfolio to a risk-free asset such as cash, Treasury bills or bonds.
2. Maximizing asset growth: The second objective of CPPI is to maximize the growth of the portfolio over time. This is done by investing the majority of the portfolio in a riskier asset such as stocks, real estate or commodities.

By rebalancing these two assets, the investor can achieve their desired outcome of protecting their principal investment while maximizing asset growth.

How CPPI Works

The CPPI strategy works by creating a floor for the portfolio value. This floor is calculated as a percentage of the initial investment, typically ranging from 80% to 100% of the initial investment. The floor level determines the allocation of the portfolio between the risky asset and the risk-free asset.

When the value of the risky asset rises, the portfolio is rebalanced by selling some of the risky asset and investing the proceeds in the risk-free asset. Conversely, when the value of the risky asset falls, the portfolio is rebalanced by selling some of the risk-free asset and investing the proceeds in the risky asset.

The key to CPPI’s success lies in its ability to constantly rebalance the portfolio. By doing so, it ensures that the portfolio always maintains its set floor value, thereby protecting the investor’s principle investment.

CPPI vs. Other Risk Management Strategies

CPPI is just one of several risk management strategies that investors can use to protect their portfolios. Some of the other strategies include:

• Stop-loss orders: Under this strategy, investors set a predetermined price at which they will sell a security or a portion of their portfolio to limit their losses.
• Options: This strategy involves buying options to hedge against downside risks. For example, an investor can buy put options to protect their portfolio against potential losses.
• Managed Futures: This strategy involves investing in futures contracts, which allows investors to profit from both rising and falling markets.

While each of these strategies has its own strengths and weaknesses, CPPI is particularly effective in volatile markets where other strategies may fail.

FAQs

What is the primary objective of CPPI?

The primary objective of CPPI is to protect the initial principal investment from losses while maximizing asset growth over time.

What assets are included in CPPI?

CPPI typically consists of two assets: a risky asset and a risk-free asset. The risky asset can include stocks, real estate or commodities, while the risk-free asset usually consists of cash, Treasury bills or bonds.

What is the floor level in CPPI?

The floor level is the minimum value that the portfolio can reach. It is typically set as a percentage of the initial investment and can range from 80% to 100%.

How does CPPI protect the investor’s principle investment?

CPPI protects the principle investment by constantly rebalancing the portfolio between the risky asset and the risk-free asset. By doing so, it ensures that the portfolio always maintains its floor value.

What are the advantages of CPPI?

The main advantage of CPPI is that it protects the investor’s principle investment while still allowing for asset growth. Additionally, it is particularly effective in volatile markets where other strategies may fail.

What are the disadvantages of CPPI?

The main disadvantage of CPPI is that it can be complex to implement and may require the services of a financial professional. Additionally, it may not offer as much flexibility as other risk management strategies.