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Thursday, October 27, 2011

Pros and cons of Constant Proportion Portfolio Insurance (CPPI)

Consant Proportion Portfolio Insurance (CPPI)
Risk management via asset allocation optimizes portfolio investing
Constant proportion portfolio insurance is a form of investment risk management that is based on asset allocation. In other words, it is investment insurance however it is not insured by a company that provides the insurance. According to Rama Cont and Peter Tankov of the University of Columbia Center for Financial Engineering, constant proportion portfolio insurance allows investors to make risky investments that can grow by using multiples i.e. having more 'risk-free' assets to counterbalance the riskier assets.

How of constant proportion portfolio insurance works

To insure against risky investments constant proportion portfolio insurance requires the following three  amounts and one allocation per Investment Week. In other words, one has to first define how much capital one has to invest, then decide how much is an acceptable amount to lose, then assign a percentage loss to the risky allocation of assets. These measurements are entered into a formula to arrive at an amount for asset allocation.

1. Capital              Ex. $200,000 (C)
2. Risk metric       Ex. $20,000   (D)
3. Maximum loss  Ex 75%          (M)
4. Asset structure. Ex. $26,000 in Stocks, $174,000 in Treasury Bonds

In order to arrive at #4's asset structure numbers 1-3 have to be entered into the CPPI formula. This formula basically determines how much money is allowed to be invested in a high-risk asset in order to not exceed more than $20,000 loss with a maximum asset price drop of 75%. In other words, 75% of $26,000 is equal to $20,000 using the formula  (1/M)x (D)=(1/.75) x ($20,000)= $26,000. 

To illustrate further, suppose Mr. A has $200,000 and wishes to lose no more than $20,000 and expects the riskiest assets can fall as much as 75% in value. Given these parameters constant proportion portfolio insurance can be calculated using the aforementioned formula. This however, is only half the process, as there is still the question of return on investment, and asset instruments. That is to say, what investment instruments will yield a high enough return to justify a 75% risk. First it is a good idea to look at the advantages and disadvantages of CPPI.

Advantages of constant proportion portfolio insurance

1. Does not require derivatives

Since constant proportion portfolio insurance is more of a formula or technique the financial instruments used to fulfill the requirements of that technique are flexible. This means an investor can choose investments he or she feels comfortable with rather than something more complicated or unknown.

2. Fewer management expenses

Since derivatives are not required and flexibility is allowable within the CPPI formula, financial instruments that have lower management expenses, commissions and fees can be selected to optimize the portfolios cost effectiveness.

3. Adjustable risk and reward

Another advantage of constant proportion portfolio insurance is it can be periodically adjusted. For example, if an investors risk level or total investment capital changes, the formula can easily be recalculated and assets reapportioned to suit that change.

Disadvantages of constant proportion portfolio insurance

There are a few disadvantages to constant proportion portfolio insurance. These disadvantages can be minimized with effective decision making, and accurate assessment of market risk but should be addressed to properly meet financial objectives, risk tolerance and goals.

1. Upside ROI may be unknown

Risky investments tend to not have fixed rates of return which means the portfolio could lose value and not gain a cent. For someone seeking steady consistent growth this type of asset insurance allocation is less likely to be acceptable. However, this does not have to be the case, CPPI can still be used with fixed rates of return and very low risk levels but then becomes somewhat pointless as there is nothing to really insure against.

2. Risk level estimate may be wrong

Another potential problem with CPPI is the risk level estimate may be wrong. For example, the market may drop more than the investor expects for a given asset. Moreover, a faulty risk assessment can dampen the potential ROI or cause the investor to lose more than thought possible. In light of this, it is important to balance realistic expectation  about what the market can do, and what is also most likely to occur.

3. Opportunity cost of insurance

A third problem with constant proportion portfolio insurance is the opportunity cost. Money used to insure risky assets is money not invested in other risky assets. Granted that opportunity cost may actually amount to opportunity savings if those risky assets do not perform. However, there may also be safer assets with higher returns that increase the cost of financial opportunity provided by CPPI.

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