Definition
The CPPI (constant proportion portfolio insurance) product is a guaranteed product linked to funds or hedge funds. It is one of the different available strategies on hedge funds to protect the investment in full, or a portion of the investment capital, against the falling fluctuations of the hedge fund.
The other available strategies on hedge funds to guarantee the capital are:
- Static Zero Coupon Structure
- Embedded Option Structure
- Collateralized funds/bonds obligations on portfolios on hedge funds
- Total return swap
- Insurance policy
CPPI composition
The CPPI structure uses a “Feeder Fund” to manage the portfolio dynamically. This so-called Feeder Fund is the underlying of the instrument and is composed by a portion invested in a fund or fund of funds and a portion invested in secure instruments. When the performance of the note is good, a higher portion is invested in the risky asset usually by means of leverage. When the performance is bad, then the positions held in funds are sold and money market instruments are bought. Should the fund reach a pre-specified reference level, the whole position in the funds would be liquidated. These structures provide investment with a variable participation on the NAV of the feeder fund, which usually goes from 100% to 130%.
Feeder (basket) definition
Each Note is linked to a Basket, each Basket (the “Basket”, or the “Dynamic Basket”) being composed of Shares and/or Short-Term Spread Deposit Instruments and/or a Cash Reserve and/or Pending Cash Reserve (each as defined below) and/or Zero Coupons of Reference Bonds. Each non-risky instrument is linked to a currency, interest rate and possibly a yield curve in case of Zero Coupons or Bonds, and which is not necessary the default yield curve of the currency.
Reference Level Definition
On any Reference Date, provided that no Trigger Event (as defined below) and no Basket Termination Event (as defined below) has occurred so far, the Reference Level RLi and the distance Di are:
- RLi = RBi
- Di = (Bi– RLi)
Where:
- “Bi” is the Basket Value on the Reference Date indexed by i (as defined below); and
- “RBi” is the RB Trigger Price (as defined below) in respect of the Valuation Date indexed by i.
The Target Leverage TLi is then calculated as:
- TLi= a(Di) x (Di – Dref) + b(Di), where a is the slope depending on the interval to which the distance belongs, and b the initial value for the considered interval.
Strategy description
The CPPI method of portfolio insurance uses a simplified strategy to allocate the assets dynamically over time.
The structurer starts setting a floor (the Reference Level) and investing this amount in secure instruments, which are usually Treasury bills or other liquid money market instruments.
Then, he computes a trading level, which is the investment in the risky asset (Alternative investments (hereafter AI) or hedge funds) and is calculated as the difference between the NAV and the Reference Level multiplied by a predetermined multiple (leverage factor).
The higher the multiple the more the investor will participate in an increase in the AI fund. Nevertheless, the higher the multiple the faster the portfolio will approach the floor when there is a sustained decrease in the NAV. As the trading level approaches zero, exposure approaches zero too. If the issuer could adjust his position on the risky assets continuously, then these adjustments would keep the portfolio value from falling below the floor. The portfolio will fall below the floor only if the drop is either so sharp or so sudden that the trader does not have a chance to trade and consequently to reduce his position. In the case of hedge funds, the adjustments are far away from being performed in continuous time.
Sometimes, the structurer would only have the chance to trade on monthly basis and even in that case, the chance to cash in the desired position is subject to liquidity risk. This is the reason why in some cases, structurers add a component, called the cushion or trigger buffer, which can take two different forms: it can be either a minimum amount that has to be invested in the AI fund or it can be added into the Reference Level.