Can anyone explain how constant proportion portfolio insurance works? On page 99 of Volume 6, it says that under CPPI, the target investment in stocks = m * (Portfolio Value - Floor Value), where m >1. How can “m” be greater than 1 without eating into the floor cushion or using leverage (which is not mentioned anywhere in the text)? What am I missing?
Floor Value is not equal to Cash. That is the key.
m * (total-floor) = stock value m = slope = positive value assume total assets of 100 and a floor of 75. 2 * (100-75) = 50 in stock, 50 in cash. If things go well and stocks are up 50% from 50 to 75 we get 2*(125-75) = 100 in stock, 25 in cash…so we buy more stock as things get better using the cash. The floor stayed at 75, but my cash fell to 25. Say stocks fall off to below original level (say down to 50$)…you have 2*(75-75) = 0 in stock, 75 in cash.
Thanks, june 2009. So you do use the cushion to invest in stock. What happens if you get to portfolio value 160? You then have 2* (160-75) = 170, i.e more than the portfolio itself. Is the presumption that you will move the floor value up so that you always have something in cash?
Hmmmm…good point… If you are always buying as the market moves higher, if the market RIPS, you will run out of $$ to buy stock with…maybe you are borrowing at that point - which gets back to your original question - which makes my lame attempt to answer unhelpful. Where’s CPK???
I think at some point you have to leverage up if you keep the ratio same i.e. you have to borrow in order to allocate more to stock than you have in total assets
So, floor value is predetermined and will not change throughout the process.
What is the stock value goes to 150. What would be the allocation to stock and cash?
Bingo.