Risk Management
Constant Proportion Portfolio
Insurance (CPPI)
Understand. Act.
PortfolioPraxis: Risikomanagement
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Risk Management
Content
4
The basic principle of capital protection
5
The dynamic hedging strategy concept
6
Daily allocation decision using an equity
hedge as an example
6
Improvements
7
Summary
Imprint
Allianz Global Investors
Europe GmbH
Mainzer Landstraße 11–13
60329 Frankfurt am Main
Global Capital Markets & Thematic Research
Hans-Jörg Naumer (hjn)
Dennis Nacken (dn)
Stefan Scheurer (st)
Data origin – if not otherwise noted:
Thomson Financial Datastream.
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Risk Management
Constant Proportion Portfolio
Insurance (CPPI)
Financial crisis, dot.com bubble, euro crisis – many investors’
portfolios have been confronted with serious challenges since
the turn of the century. Negative real interest rates on 10-year
German government bonds will not contribute much to the
return requirements of institutional investors. How can investors participate in the long term return opportunities provided
by risky investments while effectively limiting their risk of loss
in times of crisis? Capital protection strategies, including CPPI
as the most basic form, offer interesting approaches to this
issue.
The basic principle of capital
protection
The objective of capital protection concepts
is to allow investors to participate in the
opportunities of promising but risky investments while limiting the risk of loss during
Dr. Heidi Jäger-Buchholz
has been Head of the Multi Asset Protection team
at Allianz Global Investors since June 2009. Before
the takeover by Allianz Global Investors, she spent
8 years in portfolio management at cominvest as
Team Leader for Structured Products.
Dr. Thomas Stephan
is a Managing Director and as Head of Multi Asset
Investment & Risk Management Strategies responsible for overlay and protection mandates at Allianz
Global Investors. These lines of business currently
cover more than 28 bn EUR assets under management/assets under overlays.
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falling markets. This concept is particularly
interesting for asset classes that are exposed
to significant market price risks.
The objective is an asymmetric distribution of
returns – negative returns (or returns under
a threshold previously agreed with the investor) are to be avoided, investor participation in
positive returns should be maximized.
An obvious way to hedge a portfolio is to
purchase put options on suitable underlyings. However, a put option with a strike
price of 100 % of the current index level will
lapse worthless in a rising or steady market.
A dynamic hedging strategy like CPPI goes
down another route – no puts are bought,
protection is secured instead by rule-based
shifting the portfolio in response to market
developments. Unlike a hedge constructed
using options, a dynamic protection strategy
does not incur any explicit hedging costs
(without regards to administrative costs).
Certainly, dynamic protection strategies
cannot escape the basic laws governing the
financial markets. Ambitious protection levels
come at the price of lower participation in
positive markets. This somewhat reduced
return potential is a kind of implicit insurance
premium. What makes dynamic protection
approaches interesting is that their implicit
“insurance costs” (in terms of expected
foregone returns) are, on average, cheaper
than in the case of protection with options, as
indicated by scientific studies1 (OBPI: Option
Based Portfolio Insurance).
Another reason dynamic strategies are attractive is that they are highly flexible: they can
help to protect a wide variety of portfolio
allocations. This does not apply to the OBPI
alternative: exchange-traded options are
only available for standard indices; resorting
instead to Over-The-Counter (OTC) options
poses problems such as counterparty risk and
illiquidity.
The dynamic protection concept
In addition to the permissible investment
universe, the investor determines the protection level and the point in time when this level
shall be reached (protection horizon). Based
on this information, a rule how to mix “safe
assets” and return-seeking but risky assets
(such as equities or non-immunized bonds)
can be devised. The role of “safe assets” is
generally assigned to bonds with minimal
default-risk and maturity near the protection
horizon). The portfolio managers adjust this
ratio of risky versus safe assets on a daily basis
(if needed) so that the value of the portfolio
does not fall below the protection level at the
protection horizon.
Figure 1: Daily allocation decision using a 90 % hedge as an example
Maxloss –20 %
Multiplier = 5
Translated
into hedging
system
Risk-free
Bonds
50 Euro
Equities
75 Euro
Protection
Level
90 Euro
Risikofreie
Renten
30 Euro
105 Euro
Equities
55 Euro
105 Euro
Maxloss –20 %
Multiplier = 5
Equity market
rises by 10 %
105 Euro
Cushion 15 Euro
Cushion 10 Euro
Maxloss –20 %
Multiplier = 5
Risk-free
Bonds
50 Euro
Translated
into hedging
system
Protection
Level
90 Euro
Equities
25 Euro
Risk-free
Bonds
70 Euro
95 Euro
Equity market
falls by 10 %
Cushion 5 Euro
Equities
45 Euro
95 Euro
Risk-free
Bonds
50 Euro
95 Euro
Protection
Level
90 Euro
100 Euro
100 Euro
Equities
50 Euro
Source: Allianz Global Investors
1
Source: Rudi Zagst, Julia Kraus: Stochastic dominance of portfolio insurance strategies OBPI versus CPPI, Ann Oper Res (2011) 185: 75 – 103
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Risk Management
Both classes of assets work hand in hand:
the “return-seeking assets” have the task of
generating returns, while the “safe assets” are
instrumental to achieving the agreed protection level. CPPI’s shifting system provides the
most basic form of a rule-based dynamic
asset allocation approach. In doing so, the system pursues the objective of “as much returnseeking assets as possible” and “as little safe
assets as feasible” to achieve both return and
protection targets.
Daily allocation decision:
Example for equity protection
We will illustrate the allocation system using
the example of a 90 % protection level for
equity investments (Figure 1).
Initial allocation
The protection level is EUR 90, the amount
invested is EUR 100. Assuming a maximum
downturn on the equity markets of 20 %, an
initial allocation of EUR 50 in equities and EUR
50 in “risk-free” bonds with matching maturities is permitted.
The calculation shows that with a price
decline of 20 %, the portfolio would lose
EUR 10 (20 % of EUR 50). The remaining
EUR 40 in equities would have to be immediately shifted to the “safe assets” to help
ensure that the protection level of EUR 90 is
not compromised.
What happens in a rising or falling market
For example, if the stock market rises by 10 %
– this represents an increase in the value of
the equities in the portfolio from EUR 50 to
EUR 55 and an increase in the risk budget or
“cushion” to EUR 15 – it is possible to increase
the level of investment in the return-seeking
equity asset.
If the stock market falls by 10 % – this represents a decrease in the value of the equities
in the portfolio from EUR 50 to EUR 45 and a
decrease in the cushion to EUR 5 – the exposure to promising but risky equities must be
reduced.
This clearly demonstrates that the basic form
of CPPI is a purely pro-cyclical strategy.
The main parameters of the strategy are:
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1. The protection level and the protection
horizon, i. e. the target minimum price per
share at a specified date.
2. The downside risk taken into account
(“Maxloss”) defined as the maximum price
loss of the risky investment, usually within
a period of 24 hours, that the strategy
can withstand without jeopardising the
protection level. This parameter largely
determines the quality (confidence) of the
protection approach. Modern statistical
techniques, such as extreme value theory,
can be used to determine extreme price
risks. These techniques can provide much
more realistic estimates of the downside
risks in the financial markets than, for
example, normal distributions.
3. The investment universe: With regard to
the “safe assets” , the CPPI strategy does
not leave much leeway. “Safe” within the
context of this strategy refers only to bonds
with residual maturity matching the protection horizon as closely as possible. An
additional requirement is that the securities
shall not be exposed to either liquidity or
credit risks.
Improvements
Improving on the basic CPPI framework,
several proprietary allocation strategies have
been developed, that are used for mandates
with soft or hard protection,. In these strategies, the familiar pro-cyclical elements of
CPPI are often supplemented by anti-cyclical
components. This allows, for example, partial
profit-taking in highly overheated markets. To
remain flexible for re-entry into the market
even after strong declines, portfolio managers
can hold back part of the risk budget, which
is especially important for longer protection
horizons. These reserved parts of the risk
budget are typically released at a later date
to enable better participation in an eventual
recovery.
Furthermore, these improved and more flexible strategies also allow – unlike CPPI – an
active management of risky assets (e. g.
European, US, or emerging markets equities,
etc.), which enables the portfolio manager to
potentially generate additional returns.
Summary
The CPPI and – to a greater extent – proprietary improved strategies are flexible
modular systems, which can be individually
customized to clients’ needs with regard to
investment universe, risk budget, protection
horizon and return targets. Capital protection
approaches cannot prevent financial crises
and bubbles, but they help to ensure that
portfolios generate more stable and predict-
able returns during such markets. Just as
important for the overall investment strategy
is that these dynamic allocation solutions
support investors with the intention to leap
more confidently into higher yielding asset
classes, particularly during the current market
environment.
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Allianz Global Investors GmbH
Bockenheimer Landstr. 42 – 44
60323 Frankfurt am Main
March 2013
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