Perhaps you’ve heard of the Black-Scholes Model?
Fischer Black and Myron Scholes first met at the Massachusetts Institute of Technology (MIT) and started a working partnership that would last for 25 years. They are well known for their pinnacle achievement — the Black-Scholes Option Pricing model — which revolutionized investing and led to a Nobel Prize. However, there are many contributions that the the two made individually to the world of investing. Constant Proportion Portfolio Insurance is one of those contributions and was introduced 15 years after their original Option Pricing model.
Black and Jones introduced Constant Proportion Portfolio Insurance (CPPI) in 1987.
The strategy involves de-risking a portfolio as a predetermined cushion has been breached. Once the safety cushion has been breached the portfolio is reallocated with increasing risk free assets. The dynamic nature of the strategy responds well to market conditions that do not exceed the cushion per monthly period. An investor does not need to use options to implement the strategy.
You can download the original four page paper published in 1987 here: Black_Jones_Simplifying_Portfolio_Insurance_1987
Presented in a visual manner the strategy looks like this…
The dynamic allocation between risky and riskfree assets allows for the construction of convex payoffs similar to options without the use of option hedging. This makes the strategy more applicable to a wider range of account types that do not allow the use of derivative hedging.
Let’s look at a real world practical example on implementing CPPI…
Cushion (C) = $20,000 (P X F)
Multiple (M) = 3
Total Portfolio (P) = $100,000
Wealth Preservation Floor (F) = 80%
Initial Investment in Risky Asset = M x C
Initial Investment in Risky Asset = 3 x ($100,000 x 0.80)
Initial Investment in Risky Asset = $60,000
Initial Investment in Riskfree Asset = $40,000
The risk in CPPI trading is known as gap risk.
Gap risk occurs when you have breached below your trading cushion before reallocating your portfolio. Gap risk will occur if the loss on the risky asset is higher than 1/M. In the above example that would equate to 33.33%. It is recommended that your reallocation frequency takes into account the potential volatility over the period duration between reallocation.
Reallocation process after drawdown…
Let’s assume a 10% drawdown and reallocate the CPPI strategy.
Updated Cushion (C) = $10,000
Reallocation in Risky Asset = M x Updated C
Reallocation in Risky Asset = 3 x $10,000
Reallocation in Risky Asset = $30,000
Reallocation in Riskfree Asset = $60,000
CPPI is especially useful for mitigating bear markets and reinvesting at bottoms for outsized returns.
