A dynamic portfolio insurance strategy that aims to protect the investor is what a CPPI is. Sounds advantageous, right? But what’s the pros and cons of Constant Proportion Portfolio Insurance (CPPI)
Constant proportion portfolio insurance is a kind of investment risk management, based on the allocation of assets. In simpler words, It is the insurance of investment; however, it is not provided by a typical insurance company.
Constant proportion portfolio insurance enables an investor to make risky investments that are grown by using multiples i.e., having more ‘risk-free’ assets to counterbalance the riskier assets – According to Rama Cont and Peter Tankov of the University of Columbia Center for Financial Engineering.
Table of Content
- Pros and Cons of Constant Proportion Portfolio Insurance (CPPI)
- Advantages of Constant proportion portfolio insurance
- 1. No requirements of derivatives
- 2. Lower management expenses
- 3. Adjustable risk and reward
- Disadvantages of Constant proportion portfolio insurance
- 1. Upside ROI may be unknown
- 2. May end up on the wrong estimate of Risk-level
- 3. The opportunity cost of the insurance
Pros and Cons of Constant Proportion Portfolio Insurance (CPPI)
How constant proportion portfolio insurance works
Constant proportion portfolio insurance, to insure against risky investments, requires the following three amounts and one allocation per Investment Week. In simpler words,
- An individual first has to define what amount of capital he has to invest.
- Then decide on how much is an affordable amount for him to lose.
- Then evaluate a percentage of the loss to the risky allocation of assets.
All these measurements are put into a formula to calculate the amount for asset allocation.
- Capital = Ex. $200,000 (C)
- Risk metric = Ex. $20,000 (D)
- Maximum loss = Ex 75% (M)
- Asset structure = Ex. $26,000 in Stocks, $174,000 in Treasury Bonds
In order to arrive at #4, the asset structure, the above numbers 1-3 have to be put into the CPPI formula. Basically, this formula ascertains how much amount of money can be invested in a high-risk asset in regards to that our loss doesn’t exceed more than $20,000 with a maximum asset price drop of 75%. [ Calculation = 75% of $26,000 is equal to $20,000 using the formula (1/M)x (D)=(1/.75) x ($20,000)= $26,000. ]
Let’s take an example, assume Mr. A has $200,000 and wishes not to lose more than $20,000 and expects the riskiest asset’s price can drop as much as 75% in value. As per these given factors, constant proportion portfolio insurance (CPPI) can be calculated using the formula mentioned above.
However, this is only half of the process. Because there is still the question of return on investment and asset instruments, this refers to what instruments of investment will yield an adequately high return to justify a 75% risk.
Hereby let’s also have a look at the advantages and disadvantages of CPPI.
Also Read: 15 Best Term Insurance Plans in India 2020
Advantages of Constant proportion portfolio insurance
1. No requirements of derivatives
The Constant proportion portfolio insurance is much of a technique or formula, and the financial instruments utilized to fulfill the requirements of such technique are flexible. It implies that instead of something more complex or unknown, an investor can opt for the investment which he or she feels comfortable with.
2. Lower management expenses
As there’s no need for derivatives and flexibility is allowable within the CPPI formula, financial instruments having lower expenses of management, commissions and fees can be chosen to optimize the efficacy of portfolios cost.
3. Adjustable risk and reward
Another benefit of constant proportion portfolio insurance is it can be adjusted from time to time. For example, if the risk-level or total investment capital of an investor changes, the CPPI formula can easily be recalculated, and assets reallocated as per that modification.
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 meet financial objectives, risk tolerance, and goals properly.
1. Upside ROI may be unknown
There typically exist no fixed rates of returns in risky investments. This means the portfolio could lose value and can gain nothing. Someone who is seeking steady, consistent growth would be less likely to accept such type of asset insurance allocation. However, this does not have to be a big case, he can still be use CPPI with fixed rates of return and very low-risk levels, but then it becomes somewhat meaningless as there is nothing to really to be insured of.
2. May end up on the wrong estimate of Risk-level
Another possible trouble with CPPI is that the estimate of risk level may get wrong, if not analyzed properly. For instance, the market may fall more than the expectations of the investor for a certain asset. Moreover, a wrong risk assessment can destroy the potential ROI or cause the investor to lose more than he thought. Hence, it is highly important to analyze the practicality of expectations concerning how the market can perform and what can possibly occur.
3. The opportunity cost of the insurance
Constant proportion portfolio insurance has one more problem that is the opportunity cost. It implies- Money used to insure risky assets is money not invested in other risky assets. Opportunity cost may actually amount to opportunity savings if those risky assets do not perform. Furthermore, there may also be some sort of safer assets yielding higher returns that increase the opportunity cost of financial opportunity rendered by CPPI.