Hi all. I am using Schweser Notes and on Page 47 Book 5 it’s stated that “The M selected must be greater than 1.0 and does not change once selected, in order to produce CPPI strategy.”
Please could anyone tell me why?
Thank you.
If M>1, then when stock prices increase you buy more and more of them. So the rate of increase of stocks in your portfolio is >1. If, on the other hand, stock prices go down, you sell them at an increasing rate (>1). This produces a convex payoff diagram. I believe that M can actually change, provided it still will be higher than one (I think this is what they meant). M is selected by investor’s risk and return preferences so, intuitively it has every right to change.
When M<1, in constant mix strategy, then the diagram in convex, and you basically adjust the portfolio to target weights when stock prices change (sell when increased and buy when decreased). In buy-and-hold M=1 as you do not change your initial alliocation at all.
hi kobi. I know when M<1 and the floor value is zero this becomes a constant mix. but when the floor value is not zero, is it still a constant mix? that’s the confusing point i can’t figure out.
It is important to remember with these relationships that the constant mix is selling to the cppi when stocks are increasing due to stocks overweighting the M portion of his portfolio and he will be buying from the cppi when stocks are decreasing in value as they will make up a smaller portion on his M portion. They way I understand it this is a closed market so one buy/sell strategy has to counter the other.
It is important to remember with these relationships that the constant mix is selling to the cppi when stocks are increasing due to stocks overweighting the M portion of his portfolio and he will be buying from the cppi when stocks are decreasing in value as they will make up a smaller portion on his M portion. They way I understand it this is a closed market so one buy/sell strategy has to counter the other.
Yes it is still constant mix, hence the first C in CPPI.