CPPI – Basic Trading Rules
- Invest the majority of the initial (i.e. starting) investment into the ‘risky’ equity asset. The remaining initial funds invested in the safe assets.
- On a daily basis monitor the portfolio’s NAV and determine the current level of the ‘Bond Floor’.
- If the ‘Gap’ increases above a pre-defined (‘leverage’ ) threshold, then the portfolio’s equity allocation is increased.
- If the ‘Gap’ falls below a pre-defined (‘de-leverage’) threshold, then the portfolio’s equity allocation is decreased in favour of the safe assets.
- If the Equity component continues to fall, then ultimately the ‘Cushion’ or ‘Gap’ falls to zero, and the portfolio is fully invested in the safe asset(s). The portfolio is now ‘cash-locked’. This means the portfolio will not benefit from any subsequent increase in the ‘risky’ asset, as the entire portfolio will remain in the ‘non-risky’ asset to guarantee the minimum return at maturity. The graph below details the NAV (dark blue) of a CPPI product cashing-out as equity markets fall, and subsequently recover (light blue). The Bond Floor is represented in red.
This ‘Cashing Out’ issue in falling Equity markets can be avoided by purchasing Call Options when the ‘Cushion’ hits a predefined floor or having a minimum equity allocation. Thus, should the Equity markets then recover, the fund continues to have some equity participation.