Constant proportion portfolio insurance

"These rules are predefined and agreed once and for all during the life of the product.
"

Constant proportion portfolio insurance (CPPI) is a capital guarantee derivative security that embeds a dynamic trading strategy in order to provide participation to the performance of a certain underlying. See also dynamic asset allocation. The intuition behind CPPI was adopted from the interest rate universe.

In order to be able to guarantee the capital invested, the option writer (option seller) needs to buy a zero-coupon bond and use the proceeds to get the exposure he wants. While in the case of a bond+call, the client would only get the remaining proceeds (or initial cushion) invested in an option, bought once and for all, the CPPI provides leverage through a multiplier. This multiplier is set to 100 divided by the crash size (as a percentage) that is being insured against.

For example, say an investor has a $100 portfolio, a floor of $90 (price of the bond to guarantee his $100 at maturity) and a multiplier of 5 (ensuring protection against a drop of at most 20% before rebalancing the portfolio). Then on day 1, the writer will allocate (5 * ($100 – $90)) = $50 to the risky asset and the remaining $50 to the riskless asset (the bond). The exposure will be revised as the portfolio value changes, i.e. when the risky asset performs and with leverage multiplies by 5 the performance (or vice versa). Same with the bond.