Miller meets with another client, Harriet Kilpatrick. Kilpatrick recently married and plans to have children in the near future. Her current portfolio, which has a value of 2 million U.S. dollars (USD), is invested in equities and risk-free securities. She asks Miller to develop a rebalancing strategy that will prevent her portfolio from dropping below USD 1.25 million. Miller states that Big Trust’s investment outlook predicts that equity prices will be trending upward. Kilpatrick says that she also wants to minimize her allocation to risk-free securities during a rising market in equities. Miller tells Kilpatrick that his clients use one of three types of rebalancing strategies: a buy-andhold strategy, a constant mix strategy, or a constant-proportion portfolio insurance (CPPI) strategy. B. Select the most appropriate rebalancing strategy for Kilpatrick’s portfolio. Justify your selection with two reasons. Before submitting the answer , can any one try and explain to me because I am going crazy with the answer and not make sense to me.
Want to decrease rf allocation as markets increase
This all points to CPPI. CPPI has a fixed floor value (requirement 1) and performs well in upward trending markets due to increasing equity allocations and reducing rf allocations (requirements 1 & 2).
Remember that the formula for the equity allocation in CPPI is m x (portfolio value - floor value) where m is greater than 1. The floor value is fixed so as markets go up the portfolio value increases and therefore this increases the allocation to equities by reducing the allocation to rf.
What throws some people off is that they assume floor value = risk free allocation. This is the case in buy and hold but not in CPPI. Which is why its referred to as having a dynamic floor.
I dont know why such tricks are on the exams. Floor need not to decline and equity weight will increase as equity increase. So both b&h and CPPI works. The most appropriate could still be both. CPPi is more risky and there is no risk assessment in the case. So dunno. It’s just a case to tick ppl and not make them score 100.
Also there is no evidence from the case that the client need a dynamic floor. He want his floor not to decline . Dynamic is good when market is trending up but again it’s risky and If the expectation were wrong the floor will drop bellow the floor . So I don’t know I hate such tricks.
And to add comment on your answer the floor will not be Fixed under CPPI. Suppose it’s cash and when market trending up you will use the cash to buy more equity and causing the causion to increase.
There is no trick in this question. Buy and Hold doesn’t perform best in upward trending markets and doesn’t minimize her allocation to risk-free securities during a rising market.
Also, the floor is fixed under CPPI. The allocation to rf varies.
Explain to me how floor Will be fixed when market is treding upwards ? M(portfolio value - floor.) when equity goes up you will use the floor to buy more equity. Hence the floor should decrease here. But the causion ( portfolio value - floor) will increase dramatically. ?? Am I Wong here ? If you use b&h floor will not change at all but it’s allocation weight will decrease as equity goes up.
Floor has both cash and equity. When market goes up, equity in the floor goes up. You remove cash equivelant to the increase in the floor value, and buy more equity.
I guess when market goes up the cash will decrease and the whole portfolio will increase . If market trend down the cash will increase and holding the portfolio to floor equal cash plus liquidated equity. Now it make sense to me. B&H will will work too but not the most appropriate because the floor will not be dynamic. Overall I still don’t get you when you say floor is fixed in CPPi. ?