Risk Latte - Two Decades of CPPI

Two Decades of CPPI

Rahul Bhattacharya
Aug 13, 2006

In 1986, Andre Perold, who was at that time at Harvard and Fischer Black and Robert Jones, who were then working for Goldman Sachs introduced a theory of hedging - or rather a hedging strategy - for institutional fund managers called the Constant Proportion Portfolio Insurance (CPPI). Andre Perold is also famous for the seminal paper he co-authored with Robert Merton in 1993 which for the first time connected the notion of insolvency put option with that of the risk capital.

CCPI, an extremely simple technique to implement in practice, was introduced to address many of the limitations of Portfolio Insurance technique, foremost of which was the time dependence. Unlike traditional portfolio insurance CPPI is time invariant and once implemented it can continue indefinitely and the manager does not have to trade - buy and sell securities - continuously with the passage of time.

In its simplest form, in a CPPI strategy the portfolio manager multiples the cushion, i.e. the difference between the original portfolio value and the floor, by a certain multiple greater than one and allocates that amount to the risky asset. The balance is allocated to the risk-free asset. At each point in time the manage simply makes sure, by constantly adjusting the proportion of risky and risk-free allocations using the constant multiple that the portfolio value does not fall by more than the reciprocal of the multiple between each revision and this simple rule ensures that the floor is never penetrated.

Reference : Asset Allocation for Institutional Portfolios, Mark P. Kritzman

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