Constant Proportion Portfolio Insurance in Presence of Jumps in Asset Prices

Abstract

Constant proportion portfolio insurance (CPPI) allows an investor to limit downside risk while retaining some upside potential by maintaining an exposure to risky assets equal to a constant multiple of the "cushion," the difference between the current portfolio value and the guaranteed amount. Whereas in diffusion models with continuous trading, this strategy has no downside risk, in real markets this risk is non-negligible and grows with the multiplier value. We study the behavior of CPPI strategies in models where the price of the underlying portfolio may experience downward jumps. Our framework leads to analytically tractable expressions for the probability of hitting the floor, the expected loss and the distribution of losses. This allows to measure the gap risk but also leads to a criterion for adjusting the multiplier based on the investor's risk aversion. Finally, we study the problem of hedging the downside risk of a CPPI strategy using options. The results are applied to a jump-diffusion model with parameters estimated from returns series of various assets and indices.

Keywords: Portfolio insurance, CPPI, Levy process, hedging, CPPI option, Value at Risk, jump-diffusion models

JEL Classification: G15