FIXED INCOME STRATEGY

14 July 2005

Altynay Davletova
Research Analyst - MLPF&S (UK)
CPPI for Debt Investors
Alexander Batchvarov, CFA
Research Analyst - MLPF&S (UK) How Dynamic Asset Allocation Techniques Can Provide Principal Protection?
Edward Baker
Research Analyst - MLPF&S (UK)
William Davies, CFA
Research Analyst - MLPF&S (UK)
Europe

London
+(44 20) 7995 2685
Highlights of This Issue
! CPPI Allows Investors to Limit the Downside, and Take Some of the Upside of the Market Movements
CPPI (Constant Proportion Portfolio Insurance) is a strategy that combines a risk-free asset with a risky asset to replicate the
outcome of a strategy involving a portfolio of risky assets and a put option. It allows investors to optimize returns and limit
downside risk (guaranteed principal return) by changing the allocation between the risky and the risk-free assets.

! CPPI Operates According to a Pre-determined Set of Rules

CPPI strategy is realised according to a pre-determined set of rules, involving the establishment of a floor (which is set to ensure
principal repayment at maturity) and a multiplier (which determines the amount of investments in risky assets). The floor and the
multiplier are dependent on the investor’s risk tolerance. The strategy may or may not allow for leverage.

! CPPI Ensures Investor Protection in Different Market Conditions

CPPI performs best for investors, when the market is trending. In a bullish market, it allows higher allocation to the risky assets
and benefits from its appreciation. In a bearish market, it allocates higher portion of (and ultimately the entire) portfolio to the
risk-free asset, thus protecting principal. In a highly volatile market, the floor may be hit early, thus locking investment into risk
free assets and preventing them from benefiting from the upside in case of a market recovery. In case of significant ‘jumps’ of
the market, the strategy may not be rebalanced on time (rebalancing is not continuous, but occurs in discrete times), thus leading
to underperformance of the strategy.

Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict
of interest that could affect the objectivity of this report.
Investors should consider this report as only a single factor in making their investment decision.

Refer to important disclosures on page 9. Analyst Certification on page 8.

Global Securities Research & Economics Group RC#41419601 Fixed Income Strategy
CPPI for Debt Investors – 14 July 2005
The Basics Elements of Constant-Proportion
Portfolio Insurance
The difficulty in predicting market movements over a long period of time and
investors’ desire to limit or altogether eliminate losses in case of downside
market movements have prompted the developments of techniques, known as
Portfolio Insurance. They allow investors to limit the negative effect and take
advantage of the positive effects of the movements in different market sectors.
The theoretical underpinning of such techniques is the modern option pricing
theory. Two techniques, which fall within the family of Portfolio Insurance are
Option-Based Portfolio Insurance (OBPI), which as the name suggests uses
options, and the Constant-Proportion Portfolio Insurance (CPPI), which allows
for dynamic asset allocation over time, in order to achieve the above goals.
CPPI techniques were examined in detail in a Merrill Lynch research paper
Dynamic Protection, Constant Proportion Portfolio Insurance: How It Works
from Feb 6, 2003, as they relate to the equity markets. Here we highlight key
point of this technique as it is applied to debt market instruments.
! OBPI – Making Use of Puts
One way to implement portfolio insurance is by using a put option. Option-
based portfolio insurance is designed to expose an investor to limited downside
risk while allowing some participation in upside markets. The investor buys a
portfolio of risky assets as well as an European put option to sell the portfolio at
a given price (put strike price). Whatever the value of the risky asset is at
maturity, the portfolio value will be at least equal to the strike of the put. Thus
the option-based portfolio insurance allows an investor to receive a guaranteed
fixed amount at maturity (subject, of course, to counterparty risk).
The drawback of this approach is that in many cases it is not possible to
construct the desired portfolio using an option strategy because:
• option contracts are not traded in the markets for every financial
instrument.
• the strike prices and expiration dates are standardised and may not meet the
needs of the portfolio manager.
• the size of the contract may be too big compared with the normally traded
sizes or the size desired by the investor.
• different types of investors face certain limitations on the use of
derivatives.
Fortunately, any option can be replicated through an adequate dynamic portfolio
2 Refer to important disclosures on page 9.
strategy1, which forms the basis for the constant-proportion portfolio insurance
technique.
! CPPI Does Not Use Derivatives
As already stated, CPPI replicates the outcome of a put option strategy through
the dynamic rebalancing of a portfolio. To illustrate it, we consider a simple
portfolio structure, when the portfolio contains two different elements: a risky
asset (e.g. government, corporate, commodity, etc.) represented by an index and
a risk-free asset (zero coupon government bond, generally). The allocation
between the two assets changes in accordance with a specified set of rules:
• An investor is promised to receive a pre-specified amount of principal at
maturity.
• The minimum value the portfolio should have in order to be able to
produce the guaranteed principal at maturity is called the floor.
• The value of the portfolio less the floor is called the cushion.
• The amount allocated to the risky asset (the risky asset exposure) is
determined by multiplying the cushion by a predetermined multiplier, as
follows:
Risky Asset Exposure = Multiplier x (Portfolio Value – Floor)
• The remaining funds are invested in the risk-free asset, usually a zero-
coupon bond or another liquid money market instrument.
For example, let us consider a portfolio of €100, a floor of €75 and a multiplier
equal to 2. The initial cushion is €25 and the initial investment in the risky asset
is €50 (€25x2). The initial mix of total portfolio is €50 risky and €50 risk-free
assets.
• Let us assume that the risky asset falls 10%; the value of the risky asset
falls from €50 to €45. At this point the total portfolio value is €95 and the
cushion is €20 (Portfolio Value €95 – Floor €75). According to the CPPI
rules the investor needs to rebalance the portfolio and the new risky
1
The key feature of the modern option pricing theory is that the price behaviour of an option is very
similar to a portfolio of the underlying stock (risky asset) and cash or zero coupon bonds (risk free
asset) that is revised over time. That is, there exists a replicating portfolio strategy, involving a risky
asset and a risk-free asset only, which creates returns identical to those of an option. According to
the standard option pricing theory, by continuously adjusting a portfolio consisting of a risky and
risk free assets, an investor can exactly replicate the return of a desired option contract (Bird,
Cunningham, Dennis, Tippett, 1990). In reality a continuous adjustment is impracticable and
trading takes place only in discrete times. If trading take place reasonably frequently, hedging
errors could be relatively small and uncorrelated with the market returns but, on the other hands,
the transaction costs may have a considerable impact on the strategy profitability. Discrete time
rebalancing implies that CPPI cannot replicate the option without hedging errors; thus hedging
errors should be considered when the investor re-balances the portfolio.
 CPPI for Debt Investors – 14 July 2005

position will be €40 (Multiplier 2 * Cushion €20), which requires a sale of

Chart 1: Risky Asset Exposure for Different Multipliers and No Leverage
€5 of the risky asset (Actual Risk Asset €45 – Desired Risky Asset €40)
and the investment of proceeds in the risk-free asset. 120

• If the risky asset falls again, more of it will be sold. 100

• On the other hand, if the value of the risky asset increases, the investor will
80
begin to increase its proportion in the portfolio (note that in this example
we do not allow for leverage, which issue we will address later): 60
• In the above example if the risky asset grows by 10%, its value will
40
increase from €50 to €55 and the total portfolio value will be €105. The
cushion will be €30 (Portfolio Value €105 – Floor €75).
20
• According to the CPPI rule the investor needs to rebalance the portfolio by
increasing the value of the risky asset from €55 to €60 (Multiplier 2 * 0
Cushion €30) and reducing the risk-free exposure (from €50 to €45) in the 0 10 20 30 40 50 60 70 80 90 100
C u sh io n (% o f P o rtfo lio )
portfolio.
m =1 m =2 m =4 m =8
The Floor
The floor can be defined as the minimum value the portfolio should have in Source: Merrill Lynch
order to be able to produce the guaranteed principal at maturity. It works as a
trigger point, which if reached will cause the portfolio to be invested 100% in The multiplier depends on the risk tolerance of the investors: the higher the
the risk-free asset until maturity. In this situation the investor may receive the multiplier, the riskier the investor’s strategy and vice versa2. The higher the
promised principal, but he may lose some or all of his interest on that principal, multiplier, the larger the rebalancing and the higher the probability of a gain
and the overall return on his investment may fall below the risk-free rate (the when the market rallies, but at the same time the higher the probability that the
rate on the risk-free asset). portfolio reaches the floor in case of a market downturn (ie the faster the shift
If the investor is guaranteed the full or partial protection of the invested capital into risky assets in an upward market movement, and the slower the shift into
only (the principal is equal to or less than the invested capital), the floor value at risk free assets in a downward market movement).
any time should be equal to the promised amount discounted at risk-free-rate. In As shown above, the multiplier is the key element of the strategy. The
case of partial protection the floor may be also fixed at the promised amount of principal traditional CPPI consider a constant multiplier (Constant-Proportion strategy).
If the investor is guaranteed the full protection of the invested capital plus the However, there are many versions of CPPI strategies, which introduce a
specified return (spread), the floor at any time should be equal to the invested dynamic multiplier. In fact, for a desired portfolio performance it would be
capital, discounted at the risk-free rate plus the spread. useful for the multiplier to change in accordance with the risky asset volatility:
The Multiplier • For example, if an investor has a low risk profile, the multiplier could
The multiplier represents the sensitivity of the risky asset exposure to the value change in the opposite direction to the risky asset’s volatility (the higher
of the cushion. It affects directly the performance of the portfolio and the the risky asset’s volatility, the lower the multiplier, and vice versa).
probability of the portfolio reaching the floor. The multiplier determines the
extent of the rebalancing needed after a change in the cushion. As shown on • On the other hand, if the investor has a high risk tolerance, the multiplier
Chart 1, a cushion of 20% and a multiplier of 1 suggests risky assets of 20% in could increase along with the volatility of risky asset and vice versa.
the portfolio (and 80% risk free assets). For a multiple of 2, that percentage In the first case, the investor will not take large profit if the risky asset
increases to 40%, and so on. We note that a multiple of 8 produces a risky asset appreciates, but the probability of reaching the floor (and the portfolio being
of 100%, not 160%, given that in this example, no leverage is allowed. locked in the risk-free asset only) is lower in a market downturn. In the second
2
Black, Perold, 1992

Refer to important disclosures on page 9. 3

CPPI for Debt Investors – 14 July 2005

case, the investor will succeed in taking profit from a risky asset’s upward
Chart 2: CPPI Strategy, Upward Market Trend
movements, but the probability of hitting the floor in a downward market
movement also rises. Thus, there is a trade-off that has to be addressed by the
1200
investor depending on his risk tolerance and related asset allocation profile.
Various volatility-related variables can be used to adjust the multiplier such as 1150
current, implicit or historical volatility, but this aspect goes beyond the purpose
of this paper and we assume the multiplier to be constant. 1100
The Leverage
1050
When the multiplier and the floor are chosen in such a way that the investment
in the risky asset exceeds the portfolio value, the strategy will require selling 1000
short the risk-free asset or borrowing an amount equal to the shortfall (i.e.
Multiplier * Cushion - Portfolio Value). Generally short-selling strategy is the 950
easier to implement, although it is a riskier one.
900
When no leverage is allowed, the risky asset exposure is limited to the total asset 1 21 41 61 81 101 121 141 161 181 201 221 241
value. In this case the asset allocation rule should look like Time (weeks)

Risky Asset Exposure = min (Portfolio, Multiplier x (Portfolio– Floor)) Risky Asset Portfolio Risk Free

It is important to distinguish whether leverage is allowed or not. If leverage is Source: Merrill Lynch
allowed, then the manager can invest more than the value of portfolio in the
risky assets (or sell short the risk-free asset). As a result the CPPI with leverage Chart 3 shows that in a downward market the CPPI strategy will outperform the
may outperform the risky asset in a rallying market, while the CPPI with no risky asset, because the proportion of risk-free asset will increase and the
leverage may only perform on par with the risky asset in the same situation. portfolio will be influenced less by the decline in the risky asset performance.
In this example, although the portfolio outperforms the risky asset, we can see
Application of CPPI that the CPPI strategy still underperforms the risk-free asset.
When does the CPPI strategy work well? As mentioned earlier, once the portfolio value falls below the floor (which
grows at risk free rate above), the entire portfolio will be invested in the risk-
The examples of how the CPPI strategy works in upward and downward
free asset until maturity. We highlight this aspect of the CPPI strategy: in such a
markets are shown in Chart 2 and Chart 3, respectively. We consider the
situation the investor will not be able to take profit from the possible future
following inputs: initial portfolio value of 1000, principal protected at maturity
rallies of the risky asset, which reduces the efficacy of the strategy. On the other
950, multiplier of 4, risk-free rate of 1.56% and no leverage. The floor at the
hand, a continuous rebalancing may not be feasible because of the high
beginning is the PV of 950 at 1.56% (or 880.52). The strategy is rebalanced in
transaction costs that the investor is likely to face.
discrete times. The risky asset index has been simulated using a lognormal
process, which is typically what corporate and government bond indices follow.
Chart 2 shows that in upward markets with a well defined trend, the CPPI
strategy allows the portfolio to benefit from the positive market performance
and, at the same time, to limit the effect of negative performance that may
happen in short periods within the long upward trend. The strategy outperforms
both the risky and risk free assets.

4 Refer to important disclosures on page 9.

 CPPI for Debt Investors – 14 July 2005

condition of slow downward movement as discussed on Chart 3, however,

Chart 3: CPPI Strategy, Downward Market Trend
the jump down can cause the portfolio to ‘freeze’ (performance revert to
risk free asset only) rapidly and unexpectedly.
1080
• In markets, experiencing spikes (say exceptional up and down movements
in short time intervals) the risk to the CPPI strategy is that rebalancing
1030 occurs at the time of the spike.
Exposure Constraints
980 So far we have discussed the CPPI strategy with no constraints. It means that
the risky asset exposure can be as high as 100% of the portfolio with no
930 leverage, or more with leverage. Sometimes the CPPI is implemented with
additional constraints: for example, the risky exposure may not be allowed to
exceed a given percentage of the portfolio (say, 50%).
880
1 21 41 61 81 101 121 141 161 181 201 221 241 To illustrate the effect of the constraints on Chart 4 we show the performance of
Time (weeks) the risky asset and the CPPI strategy with and without the 50% constraint and
Risky Asset Portfolio Risk Free
the floor growing at a risk-free rate.

Source: Merrill Lynch Chart 4: CPPI with and without the 50% Exposure Constraint
1100
Next we summarise briefly the expected performance of the CPPI technique
under different market conditions: 1080

1060
• In a market with a well-defined trend, CPPI performs well. In a bull
market, the strategy leads the investor to buy more of the risky asset as it 1040
rises and thus participate in its appreciation. In a bear market the 1020
portfolio performance should at least guarantee that the principal is
preserved, Such a strategy will put more and more into the risk-free asset as 1000
the risky asset value declines, reducing the exposure to the risky asset to 980
zero, as the portfolio approaches the floor.
960
• In oscillating markets, such as a mean-reverting one with low volatility,
940
the strategy performance will depend on the frequency of reversion and the 1 21 41 61 81 101 121 141 161 181 201 221 241
frequency of rebalancing. We distinguish between low frequency reversion Time (weeks)
and high frequency reversion. Only if the rebalancing happens more
frequently than the reversion will the CPPI capture the market movement, Risky Asset CPPI without Constraint CPPI with Constraint
but in this case it is possible that the strategy faces higher transaction costs.
*The floor grows at a constant rate
• In cases when the market experiences jumps (the latter tend to be Source: Merrill Lynch
characteristic of the commodity, interest rate, exchange rate markets), we
distinguish between jumps-up or jumps-down. If the market moves sharply
up, the portfolio benefits from the upside of the performance of the risky
assets. In a downward jump, the CPPI strategy faces the risk that the
portfolio value falls to or below the floor rapidly and as a result the
portfolio is allocated entirely into risk-free assets. This can occur under the

Refer to important disclosures on page 9. 5

CPPI for Debt Investors – 14 July 2005

There is an advantage and a drawback to using a constraint on the risky asset Which asset classes can the CPPI strategy be applied to?
exposure. The advantage is that CPPI with exposure constraints is more The CPPI is a strategy that may guarantee the return of invested capital at
defensive than in the one without constraints because there is a minimum maturity and at the same time succeed in reducing the volatility of portfolio
proportion of risk free asset, which limits investor exposure to downward market returns. CPPI is the most popular and efficient form of the portfolio insurance
movement. This strategy may perform well, when the investor has a low risk techniques and many types of deals offering exposure to various risky assets
profile. The drawback is that CPPI with constraints will perform worse than have been structured using it. Its main advantages are that it does not involve
the one without constraints, when the market is growing. investment in options, is suitable for portfolios consisting in all types of
Obviously the CPPI strategy with constraints has also the effect of reducing the marketable securities and is relatively simple to understand and implement.
portfolio volatility (see Chart 5, Exponentially Weighted Moving Average Using CPPI, protected securities benefit from the return on the risky assets with
Volatility3). As we can see the CPPI strategy reduces portfolio volatility with minimal risk of losing capital at maturity.
respect to the market volatility, but such reduction is even higher for CPPI Generally, the CPPI strategy can be applied to many assets classes:
strategy with exposure constraints.
• equity, (for detailed discussion please refer to the report mentioned earlier)
Chart 5: Exponentially Weighted Moving Average Volatility* • fixed income, e.g. corporate bond portfolios – as mentioned, their
performance is characterised by trends, under which conditions CPPI works
0.003 well.
0.0025 • commodities - energy, non-energy and agricultural commodities markets
are characterised by short periods of extremely high volatility, spikes and
0.002 jumps. CPPI can be used to reduce portfolio volatility and achieve
principal repayment.
0.0015
• structured products, e.g. CDO equity – CPPI can be used in the context of
0.001 structuring principal guaranteed investments.
0.0005 • hedge funds or funds of funds – depending on their strategies, they can
exhibit high or low volatility, as well as high dependence on manager
0 performance. CPPI can help address volatility and manager issues, as well
1 21 41 61 81 101 121 141 161 181 201 221 241 as principal protection.
Time (weeks)
• long/short combinations, e.g. long/short synthetic corporate exposures –
Risky Asset CPPI no const CPPI with const
CPPI can provide principal protection to such structures.
Source: Merrill Lynch

References
Bird, R., Cunningham, R., Dennis, D., Tippett, M., 1990. Portfolio Insurance: a simulation under
3 different market conditions. Insurance: Mathematics and Economics 9, 1-19
When we calculate volatility using the customary methods (i.e. standard deviation) we don't take
into account the order of observations. Additionally, all observations have equal weights in the Black, F., Perold, A.F., 1992. Theory of Constant Portfolio Insurance. Journal of Economic
formulas. But the most recent data about asset's movements is more important for volatility than Dynamics and Control 16, 403-426
more dated data. That is why, the recently recorded statistical data should be given more weight
than older data. One of the models that operate off of this assumption is the Exponentially Weighted Black, F., Scholes, M., 1973. The pricing of options and corporate liabilities. Journal of Political
Moving Average Volatility. Economy 81, 637-654

6 Refer to important disclosures on page 9.

 CPPI for Debt Investors – 14 July 2005

where C is the cushion and

APPENDIX:
Application of CPPI dZ t = (m(µ − r ) + r )dt + mσdWt
⎛ ⎛ 1 ⎞
⎞
( )∫ e
1 −⎜ Z s − m 2σ 2 s ⎟
The CPPI method is based on dynamically rebalancing the portfolio of a risky Z t − m 2σ 2t
Vt = Ft + e 2 ⎜V − F + r − r t
⎝ 2 ⎠
Fs ds ⎟
and risk-free asset according to a set of pre-defined rules, as explained in this ⎜ 0 0
0 ⎟
report. In this appendix we provide a brief description of the mathematics ⎝ ⎠
behind the CPPI technique.
The evolution of a portfolio is described by the following stochastic differential Let us assume that r = r , then the cushion grows according to a lognormal
equation process. Obviously, if the cushion ever descends to zero then the portfolio is
completely invested in the risk-free asset. In continuous time the probability
dS t
E t + rdt (Vt − E t )
that this happens is zero; however, the cushion can be arbitrarily small. At the
dVt = same time the cushion can be arbitrarily large and hence the exposure is large as
St
well. Thus, the method assumes an unlimited credit at risk-free rate.
where Vt is the value of the portfolio at time t, with t > 0, St is the price of risky
asset at time t, Et is the exposure or the investment in risky asset at time t, r is At maturity, the portfolio will be completely described and thus it properties can
the risk-free rate. be studied. When r = r , we have
Let us consider the simple case where the floor grows at a fixed rate r that is ⎛ ST ⎞
m
− β mT
less or equal to the risk-free interest rate r. The guaranteed amount is V0 and VT = V0 + C 0 e ⎜⎜ ⎟⎟
⎝ S0 ⎠
Ft = F0 e rt where
F0 ≥ V0 e − rT ⎛ mσ 2 ⎞
where F is the floor. β m = (m − 1)⎜⎜ + r ⎟⎟
⎝ 2 ⎠
Considering a general case, we suppose the index follows the standard model
At this point we have a payoff shown as a function of the risky index and it is
dS t path-dependent.
= µdt + σdWt The method described above takes full advantage of the market rises since there
St
is no constraint on the exposure. Suppose, now, that we impose a realistic
where W is a standard Brownian motion, and µ and σ are positive constants. constraints such that
The example of the evolution of the risky asset has been simulated and shown in
Chart 4 in the body of the report. 0 < Et < pVt
Let us consider now the risky exposure and suppose that we have no constraints where p > 0 so that
on the maximum exposure.
Et = min (mC t , pVt )
In auto-financing framework, any amount borrowed is instantly subtracted from
the value of portfolio at the risk-free rate. The multiplier will be chosen
arbitrarily. The evolution of total asset value can be described as follow
dVt = C t dZ + rFt dt

Refer to important disclosures on page 9. 7

CPPI for Debt Investors – 14 July 2005

Then we have

⎧
⎪V rdt Vt ≤ Ft
⎪ t
⎪ m
dVt = ⎨(Vt − Ft )dZ t + Ft rdt Ft < Vt < Ft
⎪ m− p
⎪ m
⎪Vt dX t Vt ≥ Ft
⎩ m− p
where
dX t = ( p (µ − r ) + r )dt + pσdW

Analyst Certification
We, Altynay Davletova and Alexander Batchvarov, hereby certify that the views each of us has expressed in this research report accurately reflect each of our respective
personal views about the subject securities and issuers. We also certify that no part of our respective compensation was, is, or will be, directly or indirectly, related to the
specific recommendations or view expressed in this research report.

8 Refer to important disclosures on page 9.

 CPPI for Debt Investors – 14 July 2005

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Refer to important disclosures on page 9. 9