Journal of Investment Strategies

Design risk: the curse of constant proportion portfolio insurance

Raquel M. Gaspar and João B. Sousa

  • This paper introduces the novel concept of design risk.
  • It focuses on portfolio insurance investment strategies, including not only the classical OBPI and CPPI strategies, but also naïve strategies previously overlooked in the literature.
  • It demonstrates that CPPIs exhibit significant design risk, a phenomenon not observed in the other strategies.
  • The performance of CPPIs worsens with the magnitude of the multiplier and the investment horizon, more so than due to the dynamics of the underlying asset.

This study highlights the notion that inadequately designed structured products or investment strategies have the potential to expose investors to unintended risks. We introduce the concept of design risk into the portfolio insurance literature. Specifically, our analysis focuses on constant proportion portfolio insurance (CPPI) structures and draws comparisons with classical option-based portfolio insurance as well as naive strategies such as stop-loss portfolio insurance or CPPI with a multiplier set at 1. To assess the effectiveness of these strategies, we employ conditional Monte Carlo simulations to control the terminal value of the underlying asset. Our findings reveal a noteworthy phenomenon: even in scenarios where the terminal value of the underlying asset exceeds several times its initial value, CPPI strategies can lead to a cash-lock situation. The probability of getting cash-locked is influenced more by the multiplier’s magnitude and the investment horizon than by the dynamics of the underlying asset.

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