What is Constant Proportion Portfolio Insurance?

Constant Proportion Portfolio Insurance, or CPPI for short, is a type of investment. People use it to try to make more money while limiting how much they can lose. It’s a little complicated, but we’ll explain it.

Special Purpose Entity

With CPPI, the first thing that happens is a company is created, called a special purpose entity or SPE. The SPE does the investing. It’s not a normal company that makes products or provides services. Its only job is to handle the CPPI investment.

Issuing Notes to Investors

The SPE gets money by selling notes to investors. Notes are like loans – the investors are lending their money to the SPE. The SPE promises to pay the investors back later, with interest. The SPE then uses the money from selling notes to buy investments.

Buying Low-Risk Securities

Most of the money from the notes is used to buy low-risk securities. Low-risk securities are things like government bonds. They usually pay steady interest and are unlikely to lose value. This gives the SPE a stable “cushion” of investments.

Selling Credit Default Swaps

What are Credit Default Swaps?

With the rest of the money, the SPE does something riskier to earn higher returns. It sells things called credit default swaps or CDS. A CDS is like insurance on a loan or bond. The SPE agrees that if specific borrowers don’t pay back their loans, the SPE will cover the losses.

Reference Credits and Leverage

The loans and bonds that the SPE is “insuring” with the CDS are called reference credits. And here’s where leverage comes in: the SPE sells way more CDS than the money it got from investors. For example, if investors gave the SPE $100 million, it might sell $500 million worth of CDS. So it’s using leverage – taking on a bigger risk than the money it actually has.

Potential Gains and Losses

If everything goes well and the borrowers pay their loans, the SPE collects fees for the CDS without having to pay anything out. This can lead to big profits. But if too many borrowers default on their loans, the SPE could face huge losses, more than the money it has from selling notes to investors.

Adjusting the Investment

Leverage Rebalancing Formula

To manage this risk, CPPI includes rules for adjusting the investment over time. This is called the leverage rebalancing formula. Regularly, the SPE looks at the market and decides if it needs to adjust its investments.

Spreads and Deleverage

A key thing it looks at is the “spread” on the reference credits. The spread is basically a measure of how risky the market thinks those loans and bonds are. If the spread gets bigger, it means the market sees more risk of borrowers not paying back. When this happens, the SPE sells some of its risky CDS investments. This is called deleveraging – it’s reducing the leverage and risk.

Why Investors Use CPPI

Potential for High Returns

Investors put money into CPPI because they hope it will give them high returns. If it works well, the leveraged CDS investments can make a lot of money. The returns could be much higher than just investing in normal bonds.

Some Downside Protection

At the same time, the low-risk securities provide some protection. Even if the risky CDS investments lose money, the SPE still has the stable investments to fall back on. This could limit the losses for investors compared to putting all their money into risky assets.

Access to Complex Strategies

CPPI also lets regular investors access a very complex investment strategy. Leveraged CDS investments are complicated and risky. Most individuals wouldn’t be able to do this on their own. But by buying notes from the SPE, they can participate indirectly.

Risks of CPPI

Leverage Magnifies Losses

The big risk of CPPI is that leverage goes both ways. It can increase gains, but it also magnifies losses. If many of the reference credits default, the SPE’s losses on the CDS could be huge. In an extreme case, the SPE might not have enough money to pay back the investors who bought its notes.

Complex and Opaque

CPPI is also very complex. The leverage rebalancing formula and the workings of the SPE can be hard to understand. This makes it tough for investors to really know the risks they’re taking on. The SPE provides some information but a lot of the details are opaque.

Credit Spread Volatility

Another risk is how sensitive CPPI is to changes in credit spreads. If spreads widen a lot and fast, the SPE may have to sell off its CDS investments quickly. This could lock in losses and hurt returns even if actual defaults are low. Credit spread movements are very hard to predict.