Formula: m x (Portfolio value - Floor). So let’s say m = 2, the portfolio value is 2m and the floor is 1m invested in treasuries.
Then the allocation to stocks would be 2 x (2 - 1) = 2. Am I right that the CPPI is assuming that the investor is essentially borrowing this extra 1m to be invested in stocks?
Hmm good question. With a 50% loss range (cushion) between the value and the floor, and a multiplier of 2, you are 100% invested in stocks (2m - 1m floor = 1m cushion x 2 (multiplier) = 2m invested in stocks). If stocks rise, there is no cash to buy more.
E.g. if stocks rise 10% by the next RB date, 2m x 1.10 = 2.2m - 1m floor = 1.2m cushion x 2 (multiplier) = 2.4m target in stocks
You don’t have any cash so you’d have to borrow 200k to actually RB.
In a case where there are constraints on using leverage, I’m guessing we simply top out to the upside using the above parameters, and only rebalance when the cushion is below 1m.
It’s a momentum strategy, but not a gearing strategy; you’re long both equity and cash, so there’s no leverage.
Bill,
In terms of the example I laid out above, is it safe to assume that it’s irrelevant because no reasonable investor would set CPPI rebalancing parameters that way (50% cushion and 2 multiplier)?
Yup.
Right on. Thank you kindly.
My pleasure.