Professional Documents
Culture Documents
(Richard Lu)
Associate professor in the Department of Risk Management and Insurance, Feng
Chia University,100 Wenhwa Rd., Taichung 40724, Taiwan, E-mail:
rclu@mail.fcu.edu.tw,
Tel: 886-4-24517250 ext.4132
(Ling-Yu Hsiung)
Ph.D. Student in the Program of Finance, Feng Chia University, 100 Wenhwa Rd.,
Taichung 40724, Taiwan, E-mail: lingyubear@gmail.com.tw,
ABSTRACT
The investment performance of constant proportion portfolio insurance (CPPI)
strategies is evaluated by using the economic performance measure. This
performance measure generalizes the Sharpe measure by replacing the standard
deviation by the economic index of riskiness proposed by Aumann and Serrano
(2008). For the performance evaluation, the return distributions are generated by
Monte Carlo simulations. The results show that whether the CPPI strategies can
outperform a buy-and-hold (BH) strategy depends on the level of multiplier, the
performance measure, and the market scenario. The multiplier is the most important
factor that determines whether the CPPI can outperform the BH. When the multiplier
is no more than three, the CPPI almost always outperforms the BH under the normal
return and volatility market. However, if the multiplier is five, which is a commonly
used value in applications, the CPPI is outperformed by the BH under all market
scenarios studied.
Keywords: constant proportion portfolio insurance, economic index of riskiness,
economic performance measurement
1. Introduction
Portfolio insurance (PI) is an investment strategy of eliminating downside risk or
obtaining guaranteed minimum returns while preserving some upward potential in
rising markets. This payoff pattern seems attractive for most investors. Portfolio
insurance can create various return-risk profiles by setting different minimum values
or floors for the portfolio. Setting a high floor means a high level of protection or
low risk for the portfolio, but there is also a low expected return. In contrast, a low
floor means a high-risk, but high-return profile. Portfolio insurance is a decision
making strategy involving different return-risk trade-off patterns.
To implement PI, Leland and Rubinstein (1976) first proposed an option-based
strategy by buying a put option on the underlying portfolio. If the put is not
available, it can be created synthetically. The put option, like a general insurance
contract, provides the coverage when losses occur. Those who insure their portfolios
have to pay the put price. Thus, portfolio insurance, in fact, has to sacrifice some
return for the risk reduction. Portfolio insurance is a decision making approach with
a return-risk trade-off.
To insure a portfolio, another approach is constant proportion portfolio insurance
(CPPI) introduced by Perold (1986) and Black and Jones (1987). In addition to the
floor setting, those who use CPPI strategies have to set a multiplier, which
determines how aggressively they want to participate in the up market. We have
shown that, comparing with a buy-and-hold (BH) strategy, the multiplier is the most
important factor that determines whether the CPPI can outperform the BH.
Is it better to have a portfolio insured? In a Black-Scholes economy with one
risk-free asset and one risky asset, for a hyperbolic absolute risk aversion (HARA)
utility investor, Merton (1971) and Brennan and Solanki (1981) derived the optimal
investment payoff, which consists of a floor and a power on the risky asset price. As
demonstrated by Perold and Sharpe (1988), the optimal payoff can be constructed by
CPPI strategies. Thus, theoretically, PI should outperform BH, which is no
protection at all. However, there is no clear empirical evidence to support PI. As
Dichtl and Drobetz (2011) pointed out, the standard expected utility theory cannot
provide an explanation for using PI strategies. They showed that PI is preferred by
prospect theory investors, but not expected utility theory investors. In this paper, we
reevaluate the performance of PI again according to an economic performance
measure. Based on this performance measure, we provide evidence that justifies PI
for expected utility theory investors.
Because of the downside protection, there is a cut-off point and no left tail for the
return distribution of an insured portfolio. Also, by CPPI, how the distribution skews
to the right depends on the floor and the multiplier chosen. Thus, the return
distribution is asymmetric and does not conform to a normal distribution. To
evaluate the performance, we need to consider the non-normality.
To evaluate relative performance, stochastic dominance rules may provide a
solution for investors with quite broad utility functions. Annaert, Van Osselaer, and
Verstraete (2009) used the stochastic dominance rules to compare PI strategies with
a BH strategy. Their historical simulated results showed that the BH strategy did not
stochastically dominate the portfolio insurance strategies, or vice versa. Thus,
stochastic dominance cannot provide a clear comparison or ranking of the return
distributions. This means stochastic dominance can provide partial rather than
complete ranking. This limitation can be attributed to the broad utility functions
setting. Leshno and Levy(2002) pointed out that the set of utility functions under the
second-order stochastic dominance includes all risk-averse utility functions, and
2
t
S t =m( PV t ( F T )) if W t > PV t ( FT )
(1)
3. Simulation Design
To generate the return distributions of the CPPI strategies for performance
evaluation, we use a Monte Carlo simulation. We design the simulation by mostly
following the work of Dichtl and Drobetz (2011). The key difference is that we
simulate the return of CPPI strategies with various levels of protection and
multiplier. The details of the setup are as follows.
The risky asset price is assumed to follow a geometric Brownian motion. This
price model can be written as:
1
d ln St ( 2 )dt dwt
2
(1)
where St is the risky asset price at time t, wt is a wiener process, and and
are the drift and volatility parameters. After stochastic integration, the discrete
version becomes
4
S t t S t e (
/ 2 ) t t
(2)
where is a Gaussian white noise with the standard deviation equal to 1. Based
on this equation, we simulate daily returns by setting t=1/250 , =9 11.5
, and =20 30 . There are four market scenarios: low-return and normal
volatility market (where =9% and =20%), low-return and high-volatility
market (where =9% and =30%), normal-return and normal-volatility
market (where =11.5% and =20%), and normal-return and high-volatility
market (where =11.5% and =30%). The normal-return and normalvolatility market corresponds to the scenario of the long-term developed stock
markets, as in Dichtl and Drobetz (2011).
The risk-free asset process is assumed to follow the following equation:
M t +Vt = M t e r Vt
(3)
where r is the risk-free interest rate, Mt is the price at t. In the simulations, the
interest rate is set to 4.5%.
Like most the other similar research works, we simulate the returns of the
constrained CPPI only. To simulate the CPPI strategies, the floor is 100%, 95%,
90%, 85%, or 0% of the initial amount invested. The no protection case (0%) is the
same as a BH strategy. The multiplier is set to five, three, two and one. With the
round-trip transaction costs 0.1%, the asset allocation is reset when the price of the
risk asset moves (up or down) over 2%. The investment horizon is one year. For
every simulation run, we calculate a log return which is based on the following
argument. To get the return distribution, we perform 100,000 simulation runs.
There are detail explanations about the above numbers chosen for simulations in
Dichtl and Drobetz (2011). Thus, we do not repeat them here again.
4. Performance Evaluation
In this section, we first discuss the economic index of riskiness, which is used for
constructing EPM. Then, we present the EPM for performance evaluation in the
following subsection.
4.1 Economic Index of Riskiness
Most performance measures, for instance the Sharpe measure, are kinds of
reward-to-risk measures. The risk measures often adopted are standard deviation,
semi-standard deviation, value at risk, expected shortfall, and so on. However, as
Aumann and Serrano (2008) pointed out, the common drawback of these risk
measure are the violation of monotonicity with respect to second-degree stochastic
dominance (SSD). Thus, even if portfolio A dominates portfolio B in terms of SSD,
and we know that all risk-averse investors prefer A to B, those risk measures may
indicate that portfolio B is less risky than Portfolio A.
The economic index of riskiness, the AS index, is axiomatically derived from the
theory of decision making under risk. The two key axioms are duality and positive
homogeneity. The duality requires the risk index that reflects how less riskaverse individuals accept riskier assets. Thus, it satisfies the above
monotonicity.
Aumann and Serrano (2008) defined the economic index of riskiness for
a risky asset as the reciprocal of the positive risk aversion
parameter of an individual with constant absolute risk aversion
(CARA) who is indifferent between taking and not taking the risky
asset. Under their setup, the AS index must satisfy the following equation:
5
EU ( W +S t S 0 )=U (W ) ,
(4)
(5)
EU
(6)
(7)
=t RS
RS
one-year investment risk repeated t times. And, if we want to take
out the time value involved, RS( S t ) is defined implicitly as
E e(ln S ln S r t )/ RS (S )=1
t
(8)
Pigorsch (2012), the EPM has the positive property of monotonicity with respect to
the first-order and second-order stochastic dominance. This property is not held by
most other performance measures (Homm and Pigorsch, 2012).
In applying the EPM, the subtle part is to calculate the AS index. According to
Aumann and Serrano (2008), we can obtain the index by solving AS( ~r ) in the
equation:
~r
AS( ~r )
(10)
E e
=1
Given an empirical distribution or a simulated distribution, without
assuming any distribution function, we can apply Equation (10) and
solve the AS index. This is the so-called nonparametric approach.
By assuming a probability density function for the excess return,
we might derive the formula of the AS index. This will be a
parametric approach if possible. For a normally distributed excess
return, the AS index is equal to the variance divided by two times of the mean
excess return. Thus, the EPM equals two times of the squared Sharpe measure. In
this situation, the two performance measures produce the same ranking.
and Table 7 and 8 are for the multiplier that equals one.1 For the BH, in fact, we can
regard it as a special case of the portfolio insurance with zero protection. As the
percent of the principal protected approaches zero, the CPPI will converge to the
BH. Actually, the simulated results also indicate the convergence.
We first examine the moments of the return distribution across all the tables. As
expected, the higher level of protection leads to the lower expected return and
standard deviation. Thus, CPPI reduces the volatility through eliminating downside
risk. In doing so, CPPI sacrifices some expected return. By looking at the skewness
and kurtosis, both of the BH is slightly higher than a normal distribution. 2 It is
because we use a percentage return instead of a log return. For others, it is obvious
that the CPPI with a higher floor has higher skewness and kurtosis. As expected,
these return distributions are far from a normal distribution.
Then, the standard deviation and the AS index are worth comparing. Standard
deviation is a risk measure used the most commonly, while the AS index is a new
proposed risk measure. In all cases studied here, they produce the same ranking of
riskiness. They both indicate that the CPPI with a higher level of protection has a
lower risk. However, according to the numerical results, the AS index provides a
different degree of riskiness from the standard deviation.
Under non-normality, the standard deviation might no longer be a perfect risk
measure. In this situation, the Sharpe ratio might be also questionable for a
performance measure. In Table 1, we can find that the Sharpe ratio and the EPM
produce very different performance ranking. According to the Sharpe ratio, the BH
has the highest rank. However, by the EPM, the BH is only better that the CPPI with
an 85% level of protection. The EPM gives the CPPI full protection at the highest
rank. Thus, here, we can find that the CPPI outperforms the BH only by using the
EPM.
The CPPI, with multiplier three, performs worse than the BH in the high
volatility market. From the Sharpe ratio or the EPM of Table 2, the BH gets the
highest rank over the CPPI with some level of protection. As Perold and Sharpe
(1988) demonstrated, higher volatility causes the CPPI to incur larger capital losses
because it is a dynamic strategy of buying when the market is high, and selling low
when the market is low.
When the multiplier equals five, the CPPI is outperformed by the BH under all
the market scenarios studied. The EPM and the Sharpe ratio produce the same
ranking. The lower level of the protection is, the better the CPPI performs. Thus,
even though five is the popularly used multiplier, this does not make the CPPI
perform better than the BH. Compared with the multiplier equaling three, the mean
return and the standard deviation are both higher when the multiplier equals five.
However, the percentage increase in the standard deviation is much more than that of
the mean return. Thus, although a high multiplier can create high upside potential in
the sense of mean return, it also raises the volatility. Overall, it worsens the
performance.
When we set the multiplier down to two, the CPPI with the various levels of
protection all outperform the BH under the normal volatility market in the sense of
the EPM. For the high volatility market where we expect the CPPI to perform less
well, the CPPI, with the level of protection over 95%, still performs better than the
BH. Based on the Sharpe ratio, the CPPI is also the better performer, but, the
evidence is weaker than that of the EPM. If the multiplier equals one, the CPPI
always outperforms the BH. Thus, the multiplier is quite important in determining
the performance of the CPPI.
1 Table 5-8 are listed in the Appendix.
2 A normal distribution has zero skewness and kurtosis equal 3.
8
Overall, to find out if the CPPI can outperform the BH under the expected utility
framework, there are three important keys, the performance measure, the market
scenario, and the multiplier. If we use the EPM instead of the Sharpe ratio, there is
more evidence in support of the CPPI. In the normal-return and normal-volatility
market, the CPPI performs better than in the low-return and high-volatility market.
This is consistent with Perold and Sharpe (1988) where they demonstrated that CPPI
would perform relatively well in up and less volatile markets. Finally, the CPPI often
outperform the BH when the multiplier is low. Regardless of the performance
measure or the market scenario, we find that the CPPI is always better than the BH
when the multiplier equals one. Dichtl and Drobetz (2011) used the multiplier five
and Annaert et al. (2009) used 14. The multipliers they used are too high to obtain
the good performers of the CPPI.
EPM
0.1085
0.0960
0.0939
0.0944
0.1154
Notes: The m in the title is the multiplier for the CPPI. STD stands for the
standard deviation. The AS index is the economic index of riskiness
proposed by Aumann and Serrano (2008). EPM stands for the economic
performance measure.
Sharpe ratio
0.0840
0.0977 0.1087 0.1191
0.1472
EPM
0.0194
0.0240 0.0286 0.0334
0.0474
Panel B: Expected Market Return=11.5%
% of protection
100%
95%
90%
85% 0%(BH)
Mean
0.0610
0.0761 0.0891 0.0996
0.1221
STD
0.1209
0.2027 0.2586 0.2960
0.3441
Skewness
4.5479
2.9388 2.2159 1.7705
0.9113
Kurtosis
30.6556 13.9081 8.9748 6.7236
4.4918
AS index
0.2771
0.4597 0.5622 0.6226
0.6682
Sharpe ratio
0.1322
0.1535 0.1705 0.1845
0.2240
EPM
0.0577
0.0677 0.0784 0.0877
0.1154
Notes: The m in the title is the multiplier for the CPPI. STD stands for
the standard deviation. The AS index is the economic index of riskiness
proposed by Aumann and Serrano (2008). EPM stands for the economic
performance measure.
12
6. Conclusion
In this paper, the investment performance of CPPI strategies is compared with a
buy-and-hold strategy. Because of the downside risk protection and the upside
potential of the CPPI, it generates an asymmetric and non-normal return distribution.
In addition to the Sharpe measure for evaluation, we use the economic performance
measure that generalizes the Sharpe measure to consider the non-normality. The
results show that the CPPI strategies can outperform a buy-and-hold (BH) strategy
under the expected utility theory. To reveal this evidence, the keys are the level of
multiplier, the performance measure, and the market scenario. The multiplier is the
most important factor that determines whether the CPPI can outperform the BH.
With the multiplier being no more than three, the CPPI almost always outperforms
the BH under the normal trend and volatility market. However, if the multiplier is
five, which is a commonly used value in applications, the CPPI is outperformed by
the BH under all market scenarios studied.
13
References
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portfolio insurance strategies using stochastic dominance criteria. Journal of
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Political Economy, 116: 810-835.
Black, F., and Scholes, M., 1973. The pricing of options and corporate liabilities.
Journal of Political Economy, 81: 637-654.
Black, F., and Jones, R., 1987. Simplifying portfolio insurance. Journal of Portfolio
Management, 14 (1): 48-51
Black, F., Perold, A.F., 1992. Theory of constant proportion portfolio insurance.
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Brennan, M.J., Solanki, R., 1981. Optimal portfolio insurance. Journal of Financial
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Dichtl, H., Drobetz, W., 2011. Portfolio insurance and prospect theory investors:
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Homm, U., and Pigorsch, C., 2012. Beyond Sharpe ratio: An application of the
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___________________________ . 1988. The evolution of portfolio insurance. In:
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14
Appendix
Table 5 Simulated Results under the Normal Volatility Market (m = 2)
Panel A: Expected Market Return=9%
% of protection
100%
95%
90%
85% 0%(BH)
Mean
0.0503
0.0549 0.0595 0.0641
0.0942
STD
0.0209
0.0436 0.0663 0.0890
0.2213
Skewness
1.2694
1.2694 1.2694 1.2694
0.5823
Kurtosis
5.9126
5.9126 5.9126 5.9124
3.5961
AS index
0.0333
0.0791 0.1257 0.1726
0.4555
Sharpe ratio
0.2518
0.2261 0.2181 0.2141
0.2225
EPM
0.1579
0.1246 0.1151 0.1104
0.1081
Panel B: Expected Market Return=11.5%
% of protection
100%
95%
90%
85% 0%(BH)
Mean
0.0528
0.0602 0.0677 0.0751
0.1220
STD
0.0220
0.0458 0.0697 0.0936
0.2269
Skewness
1.2739
1.2739 1.2739 1.2739
0.5841
Kurtosis
5.9475
5.9475 5.9475 5.9467
3.6071
AS index
0.0224
0.0514 0.0805 0.1097
0.2921
Sharpe ratio
0.3569
0.3326 0.3249 0.3212
0.3392
EPM
0.3498
0.2969 0.2814 0.2740
0.2636
Notes: The m in the title is the multiplier for the CPPI. STD stands for
the standard deviation. The AS index is the economic index of riskiness
proposed by Aumann and Serrano (2008). EPM stands for the economic
performance measure.
15
Sharpe ratio
0.4359
0.3823 0.3654 0.3572
0.3396
EPM
0.4531
0.3409 0.3093 0.2944
0.2643
Notes: The m in the title is the multiplier for the CPPI. STD stands for
the standard deviation. The AS index is the economic index of riskiness
proposed by Aumann and Serrano (2008). EPM stands for the economic
performance measure.
17