Risk Management. Constant Proportion. Insurance (CPPI) Understand. Act.

Transcription

1 Risk Management Constant Proportion Portfolio Insurance (CPPI) Understand. Act.

2 PortfolioPraxis: Risikomanagement 2

3 Risk Management Content 4 The basic principle of capital protection 5 The dynamic hedging strategy concept 6 Daily allocation decision using an equity hedge as an example 6 Improvements 7 Summary Imprint Allianz Global Investors Europe GmbH Mainzer Landstraße Frankfurt am Main Global Capital Markets & Thematic Research Hans-Jörg Naumer (hjn) Dennis Nacken (dn) Stefan Scheurer (st) Data origin if not otherwise noted: Thomson Financial Datastream. 3

4 Risk Management Constant Proportion Portfolio Insurance (CPPI) Financial crisis, dot.com bubble, euro crisis many investors portfolios have been confronted with serious challenges since the turn of the century. Negative real interest rates on 10-year German government bonds will not contribute much to the return requirements of institutional investors. How can investors participate in the long term return opportunities provided by risky investments while effectively limiting their risk of loss in times of crisis? Capital protection strategies, including CPPI as the most basic form, offer interesting approaches to this issue. The basic principle of capital protection The objective of capital protection concepts is to allow investors to participate in the opportunities of promising but risky investments while limiting the risk of loss during Dr. Heidi Jäger-Buchholz has been Head of the Multi Asset Protection team at Allianz Global Investors since June Before the takeover by Allianz Global Investors, she spent 8 years in portfolio management at cominvest as Team Leader for Structured Products. Dr. Thomas Stephan is a Managing Director and as Head of Multi Asset Investment & Risk Management Strategies responsible for overlay and protection mandates at Allianz Global Investors. These lines of business currently cover more than 28 bn EUR assets under management / assets under overlays. falling markets. This concept is particularly interesting for asset classes that are exposed to significant market price risks. The objective is an asymmetric distribution of returns negative returns (or returns under a threshold previously agreed with the investor) are to be avoided, investor participation in positive returns should be maximized. An obvious way to hedge a portfolio is to purchase put options on suitable underlyings. However, a put option with a strike price of 100 % of the current index level will lapse worthless in a rising or steady market. A dynamic hedging strategy like CPPI goes down another route no puts are bought, protection is secured instead by rule-based shifting the portfolio in response to market developments. Unlike a hedge constructed using options, a dynamic protection strategy does not incur any explicit hedging costs (without regards to administrative costs). Certainly, dynamic protection strategies cannot escape the basic laws governing the financial markets. Ambitious protection levels come at the price of lower participation in positive markets. This somewhat reduced return potential is a kind of implicit insurance 4

5 premium. What makes dynamic protection approaches interesting is that their implicit insurance costs (in terms of expected foregone returns) are, on average, cheaper than in the case of protection with options, as indicated by scientific studies 1 (OBPI: Option Based Portfolio Insurance). Another reason dynamic strategies are attractive is that they are highly flexible: they can help to protect a wide variety of portfolio allocations. This does not apply to the OBPI alternative: exchange-traded options are only available for standard indices; resorting instead to Over-The-Counter (OTC) options poses problems such as counterparty risk and illiquidity. The dynamic protection concept In addition to the permissible investment universe, the investor determines the protection level and the point in time when this level shall be reached (protection horizon). Based on this information, a rule how to mix safe assets and return-seeking but risky assets (such as equities or non-immunized bonds) can be devised. The role of safe assets is generally assigned to bonds with minimal default-risk and maturity near the protection horizon). The portfolio managers adjust this ratio of risky versus safe assets on a daily basis (if needed) so that the value of the portfolio does not fall below the protection level at the protection horizon. Figure 1: Daily allocation decision using a 90 % hedge as an example Maxloss 20 % Multiplier = 5 Cushion 15 Euro Maxloss 20 % Multiplier = 5 Cushion 10 Euro Equity market rises by 10 % 55 Euro Risk-free Bonds 50 Euro 105 Euro Translated into hedging system 105 Euro Protection Level 90 Euro 75 Euro Risikofreie Renten 30 Euro 105 Euro 100 Euro Protection Level 90 Euro 50 Euro Risk-free Bonds 50 Euro Equity market falls by 10 % 100 Euro 45 Euro Risk-free Bonds 50 Euro 95 Euro Translated into hedging system Maxloss 20 % Multiplier = 5 95 Euro Cushion 5 Euro Protection Level 90 Euro 25 Euro Risk-free Bonds 70 Euro 95 Euro Source: Allianz Global Investors 1 Source: Rudi Zagst, Julia Kraus: Stochastic dominance of portfolio insurance strategies OBPI versus CPPI, Ann Oper Res (2011) 185:

6 Risk Management Both classes of assets work hand in hand: the return-seeking assets have the task of generating returns, while the safe assets are instrumental to achieving the agreed protection level. CPPI s shifting system provides the most basic form of a rule-based dynamic asset allocation approach. In doing so, the system pursues the objective of as much returnseeking assets as possible and as little safe assets as feasible to achieve both return and protection targets. Daily allocation decision: Example for equity protection We will illustrate the allocation system using the example of a 90 % protection level for equity investments (Figure 1). Initial allocation The protection level is EUR 90, the amount invested is EUR 100. Assuming a maximum downturn on the equity markets of 20 %, an initial allocation of EUR 50 in equities and EUR 50 in risk-free bonds with matching maturities is permitted. The calculation shows that with a price decline of 20 %, the portfolio would lose EUR 10 (20 % of EUR 50). The remaining EUR 40 in equities would have to be immediately shifted to the safe assets to help ensure that the protection level of EUR 90 is not compromised. What happens in a rising or falling market For example, if the stock market rises by 10 % this represents an increase in the value of the equities in the portfolio from EUR 50 to EUR 55 and an increase in the risk budget or cushion to EUR 15 it is possible to increase the level of investment in the return-seeking equity asset. If the stock market falls by 10 % this represents a decrease in the value of the equities in the portfolio from EUR 50 to EUR 45 and a decrease in the cushion to EUR 5 the exposure to promising but risky equities must be reduced. This clearly demonstrates that the basic form of CPPI is a purely pro-cyclical strategy. The main parameters of the strategy are: 1. The protection level and the protection horizon, i. e. the target minimum price per share at a specified date. 2. The downside risk taken into account ( Maxloss ) defined as the maximum price loss of the risky investment, usually within a period of 24 hours, that the strate gy can withstand without jeopardising the protection level. This parameter largely determines the quality (confidence) of the protection approach. Modern statistical techniques, such as extreme value theory, can be used to determine extreme price risks. These techniques can provide much more realistic estimates of the downside risks in the financial markets than, for example, normal distributions. 3. The investment universe: With regard to the safe assets, the CPPI strategy does not leave much leeway. Safe within the context of this strategy refers only to bonds with residual maturity matching the protection horizon as closely as possible. An additional requirement is that the securities shall not be exposed to either liquidity or credit risks. Improvements Improving on the basic CPPI framework, several proprietary allocation strategies have been developed, that are used for mandates with soft or hard protection,. In these strategies, the familiar pro-cyclical elements of CPPI are often supplemented by anti-cyclical components. This allows, for example, partial profit-taking in highly overheated markets. To remain flexible for re-entry into the market even after strong declines, portfolio managers can hold back part of the risk budget, which is especially important for longer protection horizons. These reserved parts of the risk budget are typically released at a later date to enable better participation in an eventual recovery. Furthermore, these improved and more flexible strategies also allow unlike CPPI an active management of risky assets (e. g. European, US, or emerging markets equities, etc.), which enables the portfolio manager to potentially generate additional returns. 6

7 Summary The CPPI and to a greater extent proprietary improved strategies are flexible modular systems, which can be individually customized to clients needs with regard to investment universe, risk budget, protection horizon and return targets. Capital protection approaches cannot prevent financial crises and bubbles, but they help to ensure that portfolios generate more stable and predictable returns during such markets. Just as important for the overall investment strategy is that these dynamic allocation solutions support investors with the intention to leap more confidently into higher yielding asset classes, particularly during the current market environment. Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors may not get back the full amount invested. Past performance is not indicative of future performance. No offer or solicitation to buy or sell securities, nor investment advice / strategy or recommendation is made herein. In making investment decisions, investors should not rely solely onthis material but should seek independent professional advice.the views and opinions expressed herein, which are subject to change without notice, are those of the issuer and / or its affiliated companies at the time of publication. The data used is derived from various sources, and assumed to be correct and reliable, but it has not been independently verified; its accuracy or completeness is not guaranteed and no liability is assumed for any direct or consequential losses arising from its use, unless caused by gross negligence or willful misconduct. The conditions of any underlying offer or contract that may have been, or will be, made or concluded, shall prevail. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This is a marketing communication. This material has not been reviewed by any regulatory authorities, and is published for information only, and where used in mainland China, only as supporting materials to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors US LLC, an investment adviser registered with the US Securities and Exchange Commission; Allianz Global Investors Europe GmbH, an investment company in Germany, subject to the supervision of the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) RCM (UK) Ltd., which is authorized and regulated by the Financial Services Authority in the UK; Allianz Global Investors Hong Kong Ltd. and RCM Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No Z]; and Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator. 7

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