Raquel Gaspar

This paper introduces the notion of design risk into the portfolio insurance literature. It focus on the evaluation of path–dependency/independency of the most widespread portfolio insurance strategies. In particular, we look at constant proportion portfolio insurance (CPPI) structures and compare them to both the classical option based portfolio insurance (OBPI) and naïve strategies such as stop-loss portfolio insurance (SLPI), or a CPPI with a multiplier of one. The paper is based upon conditional Monte Carlo simulations to control for the terminal value of the underlying. We show that even  in scenarios where the terminal value of the underlying is several times higher its initial value, CPPIs can get cash-locked. The likelihood of ending up cash-locked increases with the size of the multiplier and the maturity, more than on the properties of the risky underlying’s dynamics. This cash-lock problem is specific of CPPIs, it goes against the European-style nature of traded CPPIs, and it adds to the strategy a risk that is unrelated to the underlying risky asset – a design risk. Design risk does not occur for path-independent portfolio insurance strategies, like in OBPI strategies, nor in naïve strategies. This study contributes to reinforce the idea that bad designing of structure products or investments strategies, may expose investors to undesired risks.

Joint work with João Carvalho and João Beleza Sousa.