Location via proxy:   [ UP ]  
[Report a bug]   [Manage cookies]                

Option On A CPPI

Download as pdf or txt
Download as pdf or txt
You are on page 1of 34

International Mathematical Forum, Vol. 6, 2011, no.

5, 229 - 262

Option on a CPPI
Marcos Escobar

Department for Mathematics, Ryerson University, Toronto

Andreas Kiechle

Technische Universitaet Muenchen

Luis Seco

Risklab Toronto, Sigma Analysis & Management, Toronto

Rudi Zagst

HVB-Institute for Mathematical Finance, Technische Universitaet Muenchen


zagst@tum.de

Abstract
In this paper we obtain closed-form expressions for the price of an
European Call option on constant-proportion portfolio insurance strate-
gies (CPPI). CPPIs are path-dependent derivatives themselves where
the underlying typically is a market index or a fund portfolio. We de-
scribe and explain the functionality of CPPIs, showing closed-form ex-
pression for the price of a CPPI assuming a Geometric Brownian Motion
and continuous as well as discrete rebalancing for the fund investment.
The sensitivities of the option to the various parameters of the model
are also derived.

Mathematics Subject Classification: 91G10, 91G20

Keywords: European Options, Constant Proportion Portfolio Insurance,


Continuous and Discrete Rebalancing

1 Introduction
The CPPI (Constant Proportion Portfolio Insurance) is an important repre-
sentative of the so-called portfolio insurance strategies, which fits within the
230 M. Escobar, A. Kiechle, L. Seco and R. Zagst

framework of dynamic asset allocation. It was first proposed in 1986 and 1988
respectively by Andre Perold for bonds (See [14]) and in 1987 by Black and
Jones for equity-investments (See [6]). Portfolio insurance first appeared in
the US at the beginning of the eighties and has gained popularity over the last
years due to various downturns of the stock markets and a stronger focus on
risk management in the asset management industry. The distinct bear mar-
ket from 2001 to 2003 strongly contributed to the rise of portfolio insurance
strategies as both institutional and private investors have become more risk
averse in their investment policy. The aim of a portfolio insurance strategy is
to protect the portfolio against bigger losses in downside markets by guaran-
teeing a certain percentage of the initial capital while maintaining the chance
for an upside participation if the assets of the portfolio do well (See, e.g., [3]
or [9]).
The properties of continuous–time CPPI strategies have been studied in the
literature. Some clarifying papers on the topic of continuous CPPIs are [4]
and [8]. The literature on CPPI also deals with the effects of jump processes,
stochastic volatility models and extreme value approaches. Nevertheless the
issue of discrete-time CPPI has been barely covered; in a working paper [2]
analyze a discrete–time version of a general CPPI strategy which is used for
risk management purposes, therefore risk measures statistics like shortfall and
expected shortfall given default are all computed under the real-world measure.
In [8] a particular case of CPPI, called a Constant Leverage Strategy (CLS)
in discrete time, was analyzed in the context of a Hedge Fund application.
In this paper we study the pricing of call options on a CPPI strategy. We price
the Option on a CPPI and examine how its price depends on various market
and CPPI-parameters for continuous and discrete rebalancing.
The paper proceeds as follows. In Section 2 we summarize the main results
on CPPI. Section 3 focuses on pricing an Option on a CPPI where the CPPI
is rebalanced continuously. To get a better understanding of the sensitivity of
this derivative to market parameters, we study its Greeks in Section 4. Section
5 deals with an Option on a discrete CPPI. Finally, Section 6 concludes.

2 CPPI in Continuous Time


The CPPI is a dynamic asset allocation strategy. A CPPI portfolio consists
of two assets, the risky asset St (e.g. a stock index) and the riskless asset Bt ,
typically a bank account. The CPPI works as follows. At first, two parameters
have to be specified: the constant multiplier and the floor (the insurance level
at maturity). The amount which is invested in a risky asset is determined by
the product of the multiplier and the excess of the portfolio value over the
floor. This product is called exposure. The remaining part, i.e. the difference
of the portfolio value and the asset exposure, is invested in the riskless asset.
Option on a CPPI 231

This implies that the strategy is self-financing. In theory the portfolio allo-
cation is adjusted continuously. The assumption of continuous rebalancing of
the CPPI ensures that the portfolio value does not fall below the floor and
thus the initially specified insurance level is guaranteed.
In the following sections we first describe the functionality of the CPPI, present
a mathematical formulation and derive a formula for the portfolio value of the
CPPI. Finally we give an expression for the leverage of the CPPI.

Let us now describe the functionality of the CPPI in five steps. To do this,
we assume a constant riskfree rate r.

1. Parameter Specification:
In t = 0 the investor has to specify the multiplicator m ≥ 0 and the floor
or insurance level F = FT which represents the minimum portfolio value
at maturity T . With V0 denoting the portfolio value in t = 0 it must
hold that
FT ≤ erT V0 ,
since the maximal riskfree return on the portfolio can be r. The current
floor Ft is obtained by discounting F for the remaining time T − t

Ft = e−r(T −t) FT .

2. The cushion Ct , the excess of the portfolio value Vt over the floor Ft , at
time t, is defined as follows:
(
Vt − Ft if Vt ≥ Ft
Ct =
0 if Vt < Ft

= max{Vt − Ft , 0}

3. The exposure Et is the product of the multiplicator m and the cushion


Ct , i.e.
Et = m · Ct (1)

4. Now the exposure Et is invested in (borrowed from) the risky asset St ,


the remaining part of the portfolio is invested in the riskless asset Bt .

5. The portfolio is rebalanced continuously which means that the exposure


Et and the investment in the riskless asset Bt are adjusted at continuous
time.

Continuous rebalancing ensures that the portfolio value Vt is always greater


than the discounted floor Ft . This in particular guarantees that the minimum
232 M. Escobar, A. Kiechle, L. Seco and R. Zagst

portfolio value VT is greater than the floor FT at time T .


The above description demonstrates that the CPPI is a procyclical investment
strategy. In the case the risky asset performs well the cushion and thus the
exposure increase. This means that more money is invested in the risky asset.
In the case of declining stock prices the cushion shrinks and money is shifted
from the risky asset to the riskless asset.
Furthermore, we can see that the CPPI is a fairly simple and flexible asset
allocation strategy. It is individually adjustable to meet the investors’ needs.
Both, the floor and the multiple reflect the investor’s risk tolerance and are
exogenous to the model. The more risk-loving the investor is the higher the
multiplicator and the lower the floor. This combination of the multiplicator
and the floor leads to a greater investment in the risky asset. The higher the
multiplicator, the more the investor will participate in an increase in stock
prices, but on the other hand the faster the portfolio will approach the floor
when there is a sustained decrease in stock prices. As the cushion approaches
zero, the exposure approaches zero, too.
Note that for certain combinations of the multiplicator, the floor, and the per-
formance of the risky asset, the exposure Et = mCt = m(Vt − Ft ) can exceed
the portfolio value Vt . This means that more than the current portfolio value
has to be invested in the risky asset. The additional financing comes from
taking a loan from the bank account. In this case the CPPI exhibits leverage.
In general to avoid that the portfolio exhibits too great leverages the CPPI
can be modified by introducing a leverage constraint.

Next we describe the CPPI mathematically. First we give a mathematical


definition of the CPPI. Based on this definition we derive a closed-form ex-
pression for the portfolio value Vt of the CPPI.

Definition 2.1. Given the investment period [0, T ], the floor FT , the mul-
tiplicator m, and the riskless rate r, the portfolio value VtCP P I of the CPPI in
t is given by

VtCP P I = ϕCP P I,B (t) · Bt + ϕCP P I,S (t) · St , t ∈ [0, T ] (2)

where
mCt
ϕCP P I,S (t) =
St
Vt − ϕCP P I,S (t)St Vt − mCt
ϕCP P I,B (t) = = , t ∈ [0, T ]
Bt Bt
To simplify the notation we will refer to Vt as the value VtCP P I of the
CPPI in t. Furthermore we will write ϕt,S and ϕt,B instead of ϕCP P I,S (t) and
Option on a CPPI 233

ϕCP P I,B (t).


Let us now present two results for the CPPI with continuous rebalancing. First
we derive a formula for the process of the cushion Ct and, using this result, we
obtain a formula for the process of the portfolio value Vt .

Lemma 2.2. In the risk-neutral world the process for the cushion Ct is
given by
dCt
= r dt + mσ dWt . (3)
Ct

Proof. The proof is carried out according to Bertrand [5]. Recall that Vt =
Ct + Ft , Et = mCt and dFt = r Ft dt = Ft dBBt
t
. Thus the cushion Ct must
satisfy:

dBt dSt
dCt = d(Vt − Ft ) = dVt − dFt = (Vt − Et ) + Et − dFt
Bt St
dBt dSt dBt dSt
= (Ct + Ft − mCt ) + mCt − dFt = (Ct − mCt ) + mCt
Bt St Bt St

= (Ct − mCt ) r dt + mCt (r dt + σ dWt ) = Ct (r dt + mσ dWt )

The result is obtained by dividing by Ct .

Using this Lemma we can derive a closed-form expression for the portfolio
value Vt of a CPPI with continuous rebalancing.

Proposition 2.3. Let m ≥ 0 be the multiplicator, r the riskless rate, Ft =


−r(T −t)
e FT the floor, and C0 the cushion in t = 0. Then the portfolio value Vt
of a CPPI with continuous rebalancing is given by

Vt (m, St ) = αt Stm + Ft , (4)


 
C0 σ2 2
where αt = S0m
· eβt and β = r − m(r − 2
) − m2 σ2 .

Proof. The proof is carried out according to Bertrand [5]. Recall that the
solution of the stochastic differential Equation (3) for Ct is

m2 σ 2
Ct = C0 e(r− 2
)t+mσWt
. (5)
234 M. Escobar, A. Kiechle, L. Seco and R. Zagst

h   i
1 σ2
We know that Wt = σ
ln SS0t − r − 2
t . By substituting this expression for
Wt into (5) we get
2 2 2
  
S
(r− m 2σ )t+mσ σ1 ln S t − r− σ2 t
Ct = C 0 · e 0

 m
St 2 2
 
r−m(r− σ2 )−m2 σ2 t
= C0 · ·e = αt Stm (6)
S0
 2 2

where αt = SCm0 · eβt and β = r − m(r − σ2 ) − m2 σ2 .
0
We know that Vt = Ct + Ft and thus with Equation (6) we get

Vt = Ct + Ft = αt Stm + Ft .

Having derived the value Vt of a CPPI in t we can now present the properties
of the option on CPPI in the next section.

3 Option on a Continuous CPPI


In this section we develop a closed-form solution for the price of a Call Option
on a CPPI in continuous time. Afterwards we conduct a sensitivity analysis to
show how changes in the market parameters influence the price of the Option
on a CPPI. Therefore, we calculate the Greeks of the price of the Option on
a CPPI, i.e. the derivatives of the price with respect to these parameters.
Furthermore, we show which impact the parameters that determine the CPPI
strategy, i.e. the multiplicator and the floor, have on the Option on a CPPI.

Let us first calculate the price of the Option on a CPPI. A Call Option on a
CPPI is an option on a portfolio that is managed according to the continuous
CPPI strategy which we have presented in Section 2. The payoff at maturity T
of this option is (VT − K)+ , where VT denotes the value of the CPPI portfolio
in T and K is the strike price of the option. We assume that the CPPI and
the Option on a CPPI have the same maturity [0, T ]. Furthermore, we only
allow for values of the strike price K which are greater than the floor F = FT
at maturity T . This seems a reasonable assumption as the continuous CPPI
by definition cannot fall below the floor, and in particular it holds VT > FT .
Thus a strike price which is smaller than the floor (K < FT ) would result
in a payoff for the option which is certainly greater than FT − K. This does
not correspond to the typical payoff of the option. As we will show later this
Option on a CPPI 235

payoff can be produced by the Option on a CPPI plus a zero coupon bond. In
Section 2 we have shown that

Vt = αt Stm + Ft , (7)
 
C0 σ2 2
where αt = S0m
· eβt and β = r − m(r − 2
) − m2 σ2 . Recall that Ft denotes
the floor of the CPPI and is given by Ft = e−r(T −t) FT . The cushion Ct is
defined as Ct = Vt − Ft .

In order to obtain the price of the Option on a CPPI in t we have to calcu-


late the discounted expectation of the payoff VT −K. The following proposition
shows the result.

Proposition 3.1. Let the dynamics of St be a Geometric Brownian Motion


in the risk-neutral world. Given a CPPI on St specified by the multiplicator
m, the floor F = FT and the investment period [0, T ], the price of the Option
on this CPPI in t with a strike price of K and the maturity T is

OoC(t) = αt Stm N(d1 ) − e−r(T −t) (K − FT )N(d2 ), (8)

where
 
αt Stm 2
ln + (r + m2 σ2 )(T − t)
K−FT
d1 = d1 (t) = √ , (9)
mσ T − t

d2 = d2 (t) = d1 (t) − mσ T − t, (10)

 
C0 σ2 2
αt = S0m
· eβt , β = r − m(r − 2
) − m2 σ2 , Ct = Vt − Ft , and Ft = e−r(T −t) F .

The proof is shown in the Appendix.

If we have a closer look at the price of the Option on a CPPI in Equation


(8), we can see that this formula resembles the price of a standard call option
in the Black-Scholes Model.1 Recall that αt Stm = Ct and Ct = Vt − Ft . Thus,
Equation (8) becomes

OoC(t) = (Vt − Ft ) N(d1 ) − e−r(T −t) (K − FT )N(d2 ), (11)


1
See, e.g., [10] p. 361
236 M. Escobar, A. Kiechle, L. Seco and R. Zagst

and the Option on a CPPI can be interpreted as an option on Vt which is


shifted by Ft . The volatility of this option is mσ compared to σ in the Black-
Scholes Model and the strike price is K − FT instead of K. With this, d1 and
d2 of the Option on a CPPI equal d1 and d2 from the Black-Scholes Model.
To get a better understanding of the Option on a CPPI we now give an
example on how its price depends on the specification of its underlying, the
CPPI. Figure 1 shows the price of the Option on a CPPI in t = 0 with the
maturity T = 3 years and the volatility σ = 20% for the underlying St of the
CPPI. The interest rate r is 5%, the value of the CPPI in t = 0 is V0 = 100
and the strike price of the Option on a CPPI is K = 100. In the graph the
multiplicator and the floor of the CPPI range from 1 to 10 and from 0 to 100
respectively. Note that this option quotes at the money, as Vt = K = 100.

Figure 1: Price Option on CPPI in t = 0, T = 3 years, σ = 0.2, r = 0.05,


V0 = 100 and K = 100

As we can see both, the multiplicator and the floor, have a strong impact
on the price of the Option on a CPPI. The price for this particular option
ranges from about 13 for m = 1 and F = 100 to more than 80 for m = 10 and
F = 0. Recall that the price of the CPPI is 100 which means that in the latter
Option on a CPPI 237

case the option is almost as expensive as its underlying (the CPPI). This fact
clarifies the enourmous upside potential of a speculative CPPI and an option
on this CPPI. The plot shows that the option price increases with an increasing
multiplicator and a decreasing floor. This can be attributed to the fact that
an increase in the multiplicator and a decrease in the floor basically have the
same effect which is that the exposure and thus the investment in the risky
asset S increases. Consequently, in this case the CPPI becomes more risky
and strongly participates in scenarios where the underlying S rises. Here we
can clearly see the option character of the Option on a CPPI. In bad scenarios
for the underlying S the CPPI will approach the floor so that the option is
virtually worthless. However, in good scenarios the payoff of the option will be
the greater the more risky the CPPI is. Especially for extreme specifications of
the CPPI, like m = 10 and F = 0, the CPPI is highly levered and its returns
amount to a multiple of the returns of S. Thus, the distribution of VT is more
skewed to the right the more risky the CPPI is. This explains the high prices
for the Option on a CPPI for risky CPPIs. Furthermore, we can see from
Equation (8) that the price of the Option on a CPPI depends on the constant
interest rate r.

Figure 2: Price Option on CPPI in t = 0, T = 3 years, r = 0.05, V0 = 100 and


K = 120

Figure 2 shows the price of the Option on a CPPI with a strike price of
K = 120 for varying σ and floor. Not surprisingly, a higher volatility of the
underlying leads to a greater option price. Again we can see that the higher
the floor the lower the option price. Thus Figure 2 confirms that the option
238 M. Escobar, A. Kiechle, L. Seco and R. Zagst

price rises as the CPPI becomes more speculative.

Let us make an interesting remark here. For specific Options on a CPPI


where the floor of the CPPI equals the strike price of the Option on a CPPI
(i.e. K = FT ) the price of the option can be derived on an easier way than by
using Formula (8), which is by setting up an arbitrage portfolio. Imagine we
have two portfolios, Portfolio 1 consisting of a CPPI with multiplicator m and
floor F , and Portfolio 2 which contains a Option on a CPPI on this specific
CPPI from Portfolio 1 with strike price K = F plus a zero-coupon bond ZB(t)
with the nominal value of F . The maturity of the CPPI, the Option on the
CPPI and the zero-coupon bond is T .
Comparing the payoffs of these two portfolios at maturity T we can see that
they are equal. The terminal value of Portfolio 1 is VT where VT > F = K,
the terminal value of Portfolio 2 is the payoff max{VT − K, 0} = VT − K of
the Option on the CPPI plus the terminal-value K of the zero-coupon bond.
Note that with continuous rebalancing the CPPI can approach the floor Ft
but Vt will never actually equal Ft as the cushion is always positive. In other
words, the payoff of the Option on a CPPI is always positive. Table 1 shows
the values of the two portfolios in t and T .

Portfolio 1 Portfolio 2
t Vt OoC(t) + ZB(t)
T VT max{VT − K, 0} + ZB(T ) = VT − K + K = VT
Table 1: Derivation of price of the Option on a CPPI using an arbitrage
portfolio

If the value of Portfolio 1 equals the value of Portfolio 2 in T their prices


have to be the same for all t < T . Otherwise arbitrage opportunities would
exist. Thus as we know the price Vt of the CPPI from Formula (4) in Section 2
and the price of the zero-coupon bond in t which is ZB(t) = e−r(T −t) ZB(T ) =
e−r(T −t) K, the price of the Option on a CPPI in t must be OoC(t) = Vt −
ZB(t) = Vt − e−r(T −t) K = Vt − Ft .
Yet, we have to keep in mind that this method to calculate the price of the Op-
tion on a CPPI only works in the case where the strike price K of the Option
on a CPPI is equal to the floor F of the CPPI that represents the underlying
of the Option on a CPPI. As it must hold for the floor that F ≤ erT V0 the
use of an arbitrage portfolio to price the Option on a CPPI is restricted to the
cases where K ≤ erT V0 .
Option on a CPPI 239

4 The Greeks of the Option on a CPPI


For the Greeks we have calculated the price of the Option on a CPPI and
shown how it is influenced by the parameters of the CPPI. In this next section
we will study its exposure to movements in the market parameters.
These sensitivities are known as the Greeks and are crucial for the issuer
(seller) of the option to control his risks resulting from his short position in
the option. Each of the Greeks measures a different dimension of the risk
of the short position. These sensitivities indicate how much the price of the
Option on a CPPI changes for a marginal change in the respective parameter.
It is important to note that the sensitivities with respect to one parameter are
calculated under the assumption that all other parameters remain constant.
Furthermore, the sensitivities are not constant but change over time. The aim
of the issuer is to hedge his position by keeping his exposure to these risks in
an acceptable range (See, e.g., [10] p. 421 f).
We have to keep in mind that we are dealing with an option on the CPPI
strategy which itself is based on an underlying St . The parameters which
determine the CPPI, i.e. the multiplicator m and the floor F , are given and
constant as the Option on a CPPI is an option on one specific CPPI strategy.
Thus, the risk factors of the Option on a CPPI are the underlying St which
is traded in the market, the volatility of St , and the interest rate r. The last
factor that influences the price of the option is the maturity T − t. Later we
will see that the maturity is not a risk factor like the ones mentioned above.
As the CPPI is not an asset that is traded in the market but on its own has
to be replicated using the underlying St and the riskless asset we calculate the
sensitivity of the Option on a CPPI with respect to St instead of Vt , the value
of the CPPI. A trader who wants to hedge the Option on a CPPI would not
make the long way round to replicate the CPPI and then hedge the Option
on a CPPI using the replicated CPPI. Furthermore, we have to be aware that
CPPIs with different specifications for the multiplicator and the floor respond
differently to changes in the risk factors. Accordinly, we will show how the
Greeks depend on varying characteristics for the CPPI.
In the following N’(x) shall denote the derivative of the cumulative standard
normal distribution with respect to x, i.e. the density function of the standard
normal distribution at x, where x ∼ N(0, 1). N’(x) is given by

1 1 2
N’(x) = √ · e− 2 x .

Furthermore, we will also need N”(x) which is given by

x 1 2
N”(x) = − √ · e− 2 x .

240 M. Escobar, A. Kiechle, L. Seco and R. Zagst

To simplify our notation we write d1 and d2 which we have derived in Equa-


tions (9) and (10) instead of d1 (t) and d2 (t).

4.1 The Delta


As we have mentioned above we calculate the delta of the Option on a CPPI
with respect to St and not, as it is usual for standard options, to the direct
underlying Vt . ∆OoC
S is the most important sensitivity for the issuer of the op-
tion who wants to hedge his exposure towards movements of St . It shows how
much the price of the Option on a CPPI changes with a marginal change of the
underlying St . Therefore, the delta is the slope of the curve which describes
the relationship between the option price and the price of the underlying St .
Let us assume for example that the delta of the option is 0.4. This means that
for a marginal change in the underlying St the change of the option amounts
to 40% of this change. In the following proposition we calculate the delta of
the Option on a CPPI.

Proposition 4.1. The ∆OoC


S of the Option on a CPPI, i.e. the sensitivity
of the Option on a CPPI with respect to changes of the value St of the CPPI,
is given by:

∂OoCt
∆OoC
S = = m αt Stm−1 · N (d1 ). (12)
∂St

Proof. The proof follows from calculating the delta of the CPPI with respect
to St (denoted by ∆S ) and then deriving the delta of the Option on a CPPI
with respect to Vt (denoted by ∆OoC
V ).

Let us now give an example for the delta of the Option on a CPPI. In the
following we will study an Option on a CPPI with maturity T = 3 years and
a strike price K = 100. The underlying of the Option on a CPPI will be a
CPPI with maturity T = 3 years, V0 = 100 and F = 80. Furthermore, we
will consider three different multiplicators m = 2, 5 and 8 for the CPPI. The
risky asset St has a volatility of σ = 0.2 where S0 = 100 and the interest rate
on the riskless asset is r = 0.05. As we want to study how the Option on a
CPPI depends on the evolution of St , we choose t = 1 for the point of our
examination (any other value could have been chosen).

Figure 3 shows the value V1 of the CPPI described above after one year
with multiplicators of m = 2, 5 and 8. We can see that the payoff of the CPPI
becomes more convex with a higher multiplicator. In the case of a downturn
Option on a CPPI 241

Figure 3: Value Vt=1 of a CPPI portfolio in t = 1, T = 3 years, σ = 0.2,


r = 0.05, F = 80, V0 = 100 and S0 = 100 for multiplicators m = 2, 5, 8

of St the CPPI with multiplicator m = 8 has considerably approached the dis-


counted floor Ft = e−r(T −t) F = 76.1 which means that the exposure is almost
zero and the CPPI is for the most part invested in the riskless asset. On the
other hand, this CPPI generates remarkable returns for high stock prices. In
the scenario where the risky asset climbed from 100 to 120 in t = 1 the value
V1 of the CPPI with multiplicator 8 went up to 180. Here the investment in
the risky asset, i.e. the exposure, amounts to E1 = m·C1 = 8(180−76.1) = 831.

Let us now demonstrate how the ∆OoC S of the Option on a CPPI depends
on the price of the risky asset St and the multiplicator m. Figure 4 shows the
∆OoC
S of the Option on a CPPI in t = 1 on the same CPPIs as before. The
strike price of the option is K = 100 again.
We can see that the ∆OoC S of the Option on a CPPI resembles the ∆S and be-
comes more convex with increasing values for the multiplicator. Note that for
low values of St the ∆OoCS is higher for low multiplicators whereas this relation
reverses for high values of St . It is evident that the ∆OoC
S approaches zero for
declining prices for St . This effect is stronger for higher multiplicators because
here the cushion is shrinking faster and thus the respective CPPI is invested
in the riskless asset to a greater extent than a CPPI with lower multiplicator.
In contrast to standard call options, the ∆OoC S can adopt values greater than
1. Whereas a standard option can never move by more than the change of
the underlying, this is very well possible for the Option on a CPPI with re-
242 M. Escobar, A. Kiechle, L. Seco and R. Zagst

spect to St . The reason for this was pointed out in Figure 3 in the case of a
high multiplicator combined with high prices for St . Here the CPPI is highly
levered due to its great exposure. Hence, merely minor changes of St cause
greater movements of Vt and thus the Option on a CPPI, which is where the
high values for the ∆OoC
S stem from.
To understand the meaning of these values for the ∆OoC
S let us give some num-
OoC
bers here. For St = 120 and m = 8 the ∆S amounts to approximalely 2.5
in t = 1. In this case the price of the Option on a CPPI is 25. A ∆OoC S of
2.5 means that the option price changes by 2.5 for a movement of St by 1.
Thus, a return of 0.8% (= (121 − 120)/120) is accompanied by a return of 10%
(= (27.5 − 25)/25) for the Option on a CPPI which is about twelve times as
much.

Figure 4: ∆OoC
S of the Option on a CPPI in t = 1, T = 3 years, σ = 0.2,
r = 0.05, V0 = 100 and K = 100

This immense power of the Option on a CPPI for high multiplicators and
rising prices for the underlying is pointed out further by the Γ of the Option
on a CPPI which we will derive in the next section.

4.2 The Gamma


In the next proposition we give the gamma (ΓOoC S ) of the Option on a CPPI.
The Γ of an option is the sensitivity of its delta with respect to the price of
the underlying St . It measures the curvature of the relationship between the
Option on a CPPI 243

option price and St . With a gamma-neutral position the influence of this cur-
vature on the performance of the delta-hedging can be reduced. A high Γ of a
delta-neutral portfolio indicates that the hedging has to occur more frequently
to keep the portfolio delta-neutral compared to a portfolio with a low Γ. The
reason for this is that in the case of a high Γ changes of the underlying St lead
to higher changes of the delta.

Proposition 4.2. The ΓOoC


S of the Option on a CPPI, i.e. the sensitivity
OoC
of the ∆S with respect to St , is given by

N 0 (d1 ) (m − 1)
ΓOoC
S = √ + m(m − 1) αt Stm−2 · N(d1 ). (13)
σ T − t · St2

Proof. The proof follows from standard calculus derivations.

Figure 5: Γ of the Option on a CPPI in t = 1, T = 3 years, σ = 0.2, r = 0.05,


V0 = 100 and K = 100

Figure 5 shows the ΓOoC


S for the example we have studied above. We can see
that the ΓS is always positive which means that the ∆OoC
OoC
S is monotonically
OoC
increasing. Furthermore, it turns out that the ΓS is increasing for m = 5
and m = 8 and decreasing for m = 2. Hence the ∆OoCS is convex for higher and
concave for lower multiplicators. The convexity of the first derivative of the
Option on a CPPI for high multiplicators again demonstrates the power of the
Option on a CPPI. A ∆OoCS that is growing even more the higher St gets shows
244 M. Escobar, A. Kiechle, L. Seco and R. Zagst

the enormous upside potential of the Option on a CPPI. This behaviour is a


result of the combination of an option on the CPPI which itself can generate
large returns due to its possibility to build up a high leverage. Note that in
contrast to the Option on a CPPI the ΓOoC
S of a standard call option approaches
zero for options which are far in the money. Here the option approximately
behaves like the underlying whereas the Option on a CPPI moves exponentially
with the underlying St .
We will now show the impact of the volatility of St on the price of the Option
on a CPPI.

4.3 The Vega


The vega of an option is the sensitivity of the option price with respect to the
volatility of the underlying.

∂OoCt
Proposition 4.3. The vega ∂σ
of the Option on a CPPI is given by
 
∂OoCt ∂d1
vega = = αt Stm tmσ(1 − m) N(d1 ) + N’(d1 ) ·
∂σ ∂σ
∂d2
−e−r(T −t) (K − FT ) N’(d2 ) · (14)
∂σ
where

 
αt Stm
∂d1 1
mT + t(1 − 3
m) ln K−FTr T −t
2 2
= √ − √ −
∂σ T −t mσ 2 T − t mσ 2
∂d2 ∂d1 √
= − m T − t.
∂σ ∂σ
Proof. The proof follows from standard calculus derivations.
The vega of the Option on a CPPI in t = 1 is presented in Figure 6. The
vega is decreasing with increasing prices for St . Furthermore, higher multipli-
cators lead to a greater influence of St (from Equation 4, Stm , St > 1), implying
lower vegas, with higher absolute values, which means that these options are
more sensitive to changes in the volatility. For m = 2 and m = 5 the vega is
positive for low values of St which can be explained as follows. In these cases
the cushion of the CPPI has diminished as Vt has approached the floor. Thus, a
strong performance of St is required for the option to get into the money again.
This performance becomes more likely if the volatility of St increases. On the
other hand of course, an increasing volatility also increases the probability of
lower prices for St . But this risk doesn’t affect the option price negatively as
Option on a CPPI 245

Figure 6: vega of the Option on a CPPI in t = 1, T = 3 years, σ = 0.2,


r = 0.05, V0 = 100 and K = 100

the downside potential of the CPPI is protected by the floor and the Option
on a CPPI quotes out of the money in this case. Accordingly, it will expire
worthless unless St rises significantly. Hence, a higher volatility enhances the
chances of the option ending in the money at maturity while the risks that
come along with a higher volatility do not hurt the option price much in this
particular case. To sum it up, the Option on a CPPI profits from a rising
volatility if the option quotes out of the money, and thus the vega is positive
for this case.

To give a complete picture of the influence of σ on the price of the Option


on a CPPI let us have a look at Figure 7. It shows how the price of the Option
on a CPPI depends on σ and t. Here we examine an at the money call for
all t as Vt = K = 100. Recall that in Figure 6 we presented the vega for this
example at one specific point in time, which was t = 1, for varying prices of
St=1 . Figure 7 demonstrates that the impact of σ on the price of the option
changes over time. Obviously the price converges to zero with decreasing ma-
turity (as Vt = K ∀ t). However, the interesting conclusion this plot presents is
the hump in the curve for the price of the Option on a CPPI. For most values
of t an increase in σ leads to higher option prices (starting from low values
for σ) while this relation is reversed for higher σs, i.e. a further increase in
the volatility results in a decrease of the option price. In the most cases an
increase in the volatility leads to lower option prices. Yet, for t = 0 the price
246 M. Escobar, A. Kiechle, L. Seco and R. Zagst

Figure 7: Price of an at the money Option on a CPPI depending on σ and t,


with T = 3 years, r = 0.05, Vt = 100, and K = 100

of the Option on a CPPI increases with rising σ.


Furthermore, the hump of the curve is moving backwards in terms of increas-
ing σ and increasing maturity, i.e. for one fixed t the peak of the price moves
to higher σs if we decrease t or increase the maturity respectively. This tells us
that on a certain level for σ an increase in σ may be favorable for the option
price for longer maturities but not for shorter maturities.

Together these inspections of the relationship of σ and the price of the


Option on a CPPI clarify that the Option on a CPPI is a complex product
which depends on many parameters. These parameters influence each other
so that varying combinations can yield in different results.
In the next section we will present the rho of the Option on a CPPI and derive
how it responds to changes of the interest rate.

4.4 The Rho


The rho measures how changes in the interest rate r influence the price of the
Option on a CPPI.
Option on a CPPI 247

∂OoC
Proposition 4.4. The rho ∂r
of the Option on a CPPI is given by
 
∂OoCt ∂d1
rho = = αt Stm (1 − m)t N(d1 ) + N’(d1 ) ·
∂r ∂r
 
−r(T −t) ∂d2
+e (K − FT ) (T − t) N(d2 ) − N’(d2 ) (15)
∂r
∂d1 ∂d2
where ∂r
and ∂r
are given by
 
∂d1 ∂d2 1 T
= = √ −t .
∂r ∂r σ T −t m

Proof. The proof follows from standard calculus derivations.

4.5 The Theta


The theta (Θ) measures the options exposure to the passage of time. Specif-
ically, it describes how the price of the Option on a CPPI changes with the
time provided that all other parameters remain constant. The basic difference
of the Θ compared to the other sensitivities we presented above is that the
future prices of St , the future volatility and interest rate are uncertain whereas
the passage of time is not. This implies that it makes no sense to hedge the
option against a change of T − t.

Proposition 4.5. The Θ, i.e. the sensitivity of the price of the Option on
a CPPI with respect to the passage of time, is given by

∂OoCt ∂d1
Θ= = αt Stm N’(d1 ) · + e−r(T −t) (K − FT )
∂(T − t) ∂(T − t)
 
∂d2
· r N(d2 ) − N’(d2 ) (16)
∂(T − t)
∂d1 ∂d2
where ∂(T −t)
and ∂(T −t)
are given by
 
αt Stm
∂d1 r+ ln m2 σ2
2
K−FT
= √ − 2 2
∂(T − t) 2mσ T − t m σ (T − t)
∂d2 ∂d1 mσ
= − √ .
∂(T − t) ∂(T − t) 2 T − t

Proof. The proof follows from standard calculus derivations.


248 M. Escobar, A. Kiechle, L. Seco and R. Zagst

5 Option on a Discrete CPPI


In the previous section we conducted a detailed examination of the Option on
a CPPI in continuous time. We found a closed-form solution for the option
price and calculated the Greeks of the option. This section deals with an Op-
tion on a CPPI where the underlying CPPI portfolio is rebalanced in discrete
time. As we know from the previous section the continuous-time application
of the CPPI ensures that the portfolio value does not fall below the floor if the
price process of the risky asset does not permit jumps. However, in practice
continuous rebalancing is not feasible. In turbulent markets it can happen
that the underlying asset falls steeply before the investor is able to rebalance
his portfolio adequately. Hence it is no longer ensured that the strategy out-
performs the prescribed floor if there is a sudden drop in market prices like
for example in the 1987 crash. The risk of falling under the floor is called
gap risk. It depends on the specification of the CPPI and usually is marginal.
Nevertheless, imposing the gap risk on the investor is not a reasonable option
because that would contradict the idea of the portfolio insurance. We can
assume that the buyer of a CPPI is completely risk averse for the terminal
value of the strategy to end up below the floor and thus would not invest in a
CPPI where he bears the gap risk. A better way to deal with the gap risk is
a hard guarantee which is given by the issuer of the CPPI or the institution
that carries out the actual trading of the assets. The issuer takes the gap risk
and considers this in the pricing of the CPPI. Accordingly a premium upon
the value of the CPPI portfolio arises.
In this section we first calculate the value of a CPPI portfolio with discrete
rebalancing including this premium. With this result we can give recommen-
dations on how frequently the rebalancing should occur depending on the mul-
tiplicator and the volatility of the underlying to minimize the probability of
falling below the floor and thus the premium. To model the gap risk we in-
troduce trading restrictions, i.e. we only allow for trading of the underlying
portfolio at specific dates.2 Thus we keep our continuous stochastic process to
model the underlying S but restrict trading to discrete time. This means that
possibly the CPPI cannot be adjusted adequately.
Let us now define the discrete CPPI. As before we consider a maturity period
T
of [0, T ] and t0 = 0. Rebalancing occurs in ts , s = 1, ..., N − 1 and N = ∆t ,
where ∆t denotes the period between two rebalancing dates. Note that in this
setup ϕS and ϕB , i.e. the number of shares held in the risky and the riskless
asset, are constant between two rebalancing dates whereas the value of the
investments in those two assets changes with movements in the prices for S
and B.
Recall that the value of the CPPI in t is given by Vt = ϕSt St + ϕB t Bt . As we

2
See, e.g. [2]
Option on a CPPI 249

do not want to allow for short positions in the risky asset, ϕSt for t ∈ [ts , ts+1 ),
s = 0, . . . , N − 1, is given by
 
S mCts
ϕt = max ,0 .
Sts
In order for the CPPI to be self-financing it must hold
ϕSts Sts+1 + ϕB S B
ts Bts+1 = ϕts+1 Sts+1 + ϕts+1 Bts+1

for all s = 0, . . . , N − 1.
In the next proposition we derive the value Vts of a CPPI portfolio in ts . Here
we have to consider that the CPPI might fall below the floor before the next
rebalancing date.

Proposition 5.1. Let


tk := min{ts |s = 1 . . . , N − 1, Vts − Fts ≤ 0}
and tk = ∞ if the minimum is not attained. Then the value Vts+1 of a CPPI
portfolio in ts+1 in the case of discrete rebalancing is given by

Vts+1 = er(ts+1 −min{tk ,ts+1 })


 
min{k,s+1}  
Y St
· (V0 − F0 ) m i − (m − 1)er∆t + Ftmin{k,s+1}  .
i=1
Sti−1
(17)
Proof. If we define rs = ln SSt ts , we get for Vts+1
s−1
 
Sts+1
Vts+1 = max mCts , 0 + (Vts − max {mCts , 0}) er∆t
Sts
St
(
m(Vts − Fts ) Ss+1 + (Vts − m(Vts − Fts )) er∆t if Vts − Fts > 0
= ts

Vts er∆t if Vts − Fts ≤ 0


(  S 
t r∆t
(Vts − Fts ) m Ss+1 − me + Vts er∆t if Vts − Fts > 0
= ts

Vts er∆t if Vts − Fts ≤ 0


(  St

(Vts − Fts ) m Ss+1 − (m − 1)er∆t + Fts er∆t if Vts − Fts > 0
= ts

Vts er∆t if Vts − Fts ≤ 0.


Iterative application of this step leads to the result.
250 M. Escobar, A. Kiechle, L. Seco and R. Zagst

Remark 5.2. If tk < tN = T , i.e. the porfolio falls below the floor in tk ,
the process for Vts switches from
ts  
Y Sti r∆t
Vts = (V0 − F0 ) · m − (m − 1)e + Fts , ts < tk
i=1
Sti−1

to
Vts = Vtk er(ts −tk ) , ts > tk
in tk . For VT we get
( Q  Sti 
(V0 − F0 ) · N i=1 m Sti−1
− (m − 1)e r∆t
+ FT if tk ≥ tN −1
VT =
Vtk er(T −tk ) if tk ≤ tN −1 .

As the next step, we want to calculate the value of the discrete CPPI
portfolio in 0. The difficulty here is that the portfolio can fall below the floor
in each ti , i = 1, ..., N , and that in this case the process for Vts , s = i + 1, ..., N
switches because the whole portfolio is invested in the riskless asset.
S σ2
Recall that St ti = e(r− 2 )∆t+σWti , where Wti ∼ N (0, ∆t).
i−1
The process for the CPPI portfolio switches if the portfolio falls below the
discounted floor Fts in ts for s = 1, ..., N − 1. This happens if Cts+1 ≤ 0
under the assumption that Cts > 0. For the cushion Cti to be positive in ti ,
i = 1, ..., N it must hold:
Sti+1
Cti+1 > 0 ⇐⇒ mCti + (Vti − mCti ) er∆t > Fti+1
Sti
 
Sti+1 r∆t
⇐⇒ (Vti − Fti ) m − (m − 1)e >0 (18)
Sti
σ2
Cti >0 ln m−1
m
+ 2
∆t
⇐⇒ Wti > =: ẑ (19)
σ
If we want to calculate the price of a CPPI portfolio with discrete rebal-
ancing, we have to distinguish between two cases, which is the case where the
portfolio never falls below the floor during the investment period (Case 1) and
the case where the portfolio does fall below the floor (Case 2). Example 5.3
illustrates the functionality of the discrete CPPI.

Example 5.3. Figure 8 gives an example of a discrete CPPI with two rebal-
ancing dates. In t = 1 the cushion can be either positive or negative depending
on the performance of the risky asset in [0, 1]. In the case the CPPI has fallen
under the floor, the whole portfolio is invested in the riskless asset and the
Option on a CPPI 251

Figure 8: Three step example for the value process of a discrete CPPI

terminal value of the CPPI is V3 = V1 e2r∆t . In the other case, the portfolio
is rebalanced according to the rebalancing rules of the CPPI. Now the same
procedure is repeated in t = 2.

Recall that, according to our definition, the discrete CPPI is self-financing.


Hence, under the risk-neutral measure the expected terminal value of the dis-
crete CPPI is
E[VT ] = erT V0 . (20)
In the following we will point out that the value of the CPPI in 0 for the
investor is not V0 . This is due to the fact that a CPPI is sold as a product
with a capital guarantee. Thus, we can imply that the buyer of the CPPI
is completely risk-averse for terminal values below the floor when buying a
portfolio insurance product. Hence, the issuer of the CPPI should guarantee a
payoff equal to or greater than the floor and therefore has to carry the gap risk
which arises in Case 2 (see below). Consequently, the payoff of the discrete
CPPI for the investor is

CP P IT = max{VT , FT }. (21)

Let us briefly clarify the notation we will use. In the following, CP P It shall
denote the value of the CPPI for the investor while Vt denotes the portfolio
value of the CPPI portfolio as we have shown in Example 5.3.
Equation (21) constitutes that the investor receives the terminal value VT of
the CPPI if the floor has not been hit during the maturity. In the case the
floor has been hit, the issuer of the CPPI pays the guaranteed amount FT .
Note that if the CPPI has fallen below the floor, it holds VT < FT , i.e. the
issuer has to pay out more than the CPPI is actually worth. Thus CP P IT
and VT differ in case the CPPI has fallen below the floor. Figure 9 illustrates
the relation of CP P IT and VT .
252 M. Escobar, A. Kiechle, L. Seco and R. Zagst

Figure 9: Relation of CP P IT and VT

Next, we want to calculate the price of the discrete CPPI. The issuer should
sell the CPPI at a price which corresponds to the expected payoff for the
investor. Hence, the price in 0 should be e−rT E[CP P IT ]. As we can see from
Figure 9 this price is composed of two parts. According to the calculation rules
for the expected value, we get
E[CP P IT ] = E[CP P IT |C1] + E[CP P IT |C2]. (22)
Let us first examine E[CP P IT |C1], where the portfolio does not fall below
the floor during the maturity, or more precisely in ts , s = 1, ..., N . In this case
it holds that CP P IT = VT and we know from Remark 5.2 that VT is given by
N  
Y Sti r∆t
VT = (V0 − F0 ) · m − (m − 1)e + FT . (23)
i=1
Sti−1

To obtain the final value VT in Case 1, VT |C1, we have to multiply VT with


the indicator of the event that the portfolio does not fall below the floor in ts ,
s = 1, ..., N .
N   ! N
Y Sti Y
VT |C1 = (V0 − F0 ) · m − (m − 1)er∆t + FT · 1{Vt >Ft } .
i=1
S ti−1 l=1
l l

(24)
Next, we examine E[CP P IT |C2]. According to our definition of the dis-
crete CPPI, the issuer guarantees a payoff of FT even if the CPPI has fallen
below the floor during the maturity period. Hence, to obtain CP P IT |C2 we
have to multiply FT with the indicator of the event that the portfolio does fall
below the floor for one ts , s = 1, ..., N . This event is the complement of the
event that the CPPI never falls below the floor (see Case 1). Thus we get
N
!
Y
CP P IT |C2 = FT · 1 − 1{Vt >Ft } .
l l
l=1
Option on a CPPI 253

Let us now calculate e−rT E[CP P IT |C1] = e−rT E[VT |C1].

Proposition 5.4. The expected value of CP P IT (and VT ) discounted to 0


for Case 1, where the portfolio does not fall below the floor during the invest-
ment period is:

e−rT E[CP P IT |C1] = F0 N(d2 )N + (V0 − F0 ) [mN(d1 ) − (m − 1)N(d2 )]N , (25)


where
2
ln m + σ ∆t √
d1 = m−1√ 2 , d2 = d1 − σ ∆t.
σ ∆t

The proof can be found in the Appendix.

Having derived e−rT E[CP P IT |C1], we now want to calculate e−rT E[CP P IT |C2]
according to Equation (25).

Proposition 5.5. The expected value for CP P IT discounted to 0 in Case 2,


i.e. in the case where the CPPI has fallen under the floor Fti in ti , i = 1, ..., N ,
is
e−rT E[CP P IT |C2] = F0 · 1 − N(d2 )N ,

(26)
2
ln m−1
m
− σ2 ∆t
where d2 is again given by d2 = σ

∆t
.

Proof. In Equation (25) we derived

N
!
Y
E[CP P IT |C2] = FT · 1− 1{Vt >Ft } . (27)
l l
l=1

Now recall Equation (19) where we showed that the CPPI falls below the
floor in ti , i = 1, ..., N if
σ2
ln m−1
m
+ 2
∆t
Wti < =: z
σ
where Wti ∼ N (0, ∆t). Thus P (Wti < z) is given by
 
z
P (Wti < z) = N √
∆t
254 M. Escobar, A. Kiechle, L. Seco and R. Zagst

and E[CP P IT |C2] is given by


  N !
z
E[CP P IT |C2] = FT · 1− 1−N √
∆t
 N !
−z
= FT · 1−N √ .
∆t

With F0 = e−rT FT , inserting z leads to the result.

Having done these calculations we can now give the price of a discrete CPPI.

Proposition 5.6. The price of a discrete CPPI in 0 is

e−rT E[CP P IT ] = F0 + (V0 − F0 ) [mN(d1 ) − (m − 1)N(d2 )]N (28)

where
m 2
ln m−1 + σ2 ∆t
d1 = √
σ ∆t
m 2
ln m−1 − σ ∆t √
d2 = √ 2 = d1 − σ ∆t.
σ ∆t

Proof. The result follows from Equation (22), using Propositions 5.4 and 5.5.

5.1 Pricing an Option on a Discrete CPPI


The transition from continuous to discrete rebalancing involves the arising of
a gap risk, i.e. the problem that the discrete CPPI can fall below the floor if
the risky asset exhibits large sudden losses. Therefore the discrete CPPI is no
longer path-independent but its value Vt depends on the course of St in [0, t].
Hence we have to check at every rebalancing date if Vt is still greater than the
discounted floor Ft or not. Accordingly, the process for Vt can switch if the
CPPI falls below the floor because in this case the whole portfolio is invested
in the riskless asset. Furthermore, as in the continuous case, we assume that
the strike price K of the Option on a CPPI is greater than the floor F . This
means that the Option on a CPPI expires worthless once the CPPI has fallen
below the discounted floor Ft in t because then the portfolio is fully invested
in the riskless asset and can never become greater than F again.
Option on a CPPI 255

For the following, let the setting be the same as in previous section. Denote
with Vts the value of a CPPI portfolio in ts , where the rebalancing occurs in
T
ts , s = 1, ..., N − 1 and N = ∆t . Furthermore, let r be deterministic again.
Recall that we derived the value Vts of a CPPI with discrete rebalancing as

Vts = er(ts −min{tk ,ts })


 
min{k,s}  
Y Sti
· (V0 − F0 ) m − (m − 1)er∆t + Ftmin{k,s}  .
i=1
Sti−1

where tk was defined as the point of time when the CPPI falls below the floor,
tk := min{ts , s = 1 . . . , N − 1|Vts − Fts ≤ 0} and tk = ∞ if the minimum is
not attained. Thus, for the value of the CPPI at maturity T we get Remark
S σ2
5.2. Furthermore, recall that St ti = e−(r− 2 )∆t−σWti , where Wti ∼ N (0, ∆t).
i−1
Under the assumption that K > FT the option on the CPPI portfolio ex-
pires worthless either if the CPPI falls below the discounted floor Fti in ti for
i = 1, ..., N −1 during the investment period (Case 1) or if VT < K at maturity
T (Case 2).
Case 1 occurs if Cti+1 ≤ 0 under the condition that Cti > 0. For the cushion
Cti+1 to be positive in ti+1 , i = 1, ..., N , Equation 18 must hold. Note that z
is constant and independent of t.

Now, if we consider the special case where K = FT , the Option on a discrete


CPPI ends up in the money at maturity T if the CPPI has not defaulted until
maturity T , i.e. Cti ≥ 0 ∀ ti , i = 1, ..., N . Then, a portfolio which is composed
of the Option on a CPPI with K = FT and a zero-coupon bond with nominal
value K, is equal to a CPPI with floor F as we have shown for the continuous
case in Section 2. Hence, the price of the Option on a CPPI can be calculated
as the difference of a discrete CPPI and F0 , where the price of the discrete
CPPI is known, Equation (28). Thus, for K = FT , the price of the Option on
a discrete CPPI in 0, denoted by OoC d (0), is given as

OoC d (0) = (V0 − F0 ) [mN(d1 ) − (m − 1)N(d2 )]N . (29)

Let us now focus on the general case where K > FT . In this case the Option
on a discrete CPPI ends up in the money at maturity T if the CPPI has not
fallen below the floor in ti , i = 1, ..., N − 1 and if the value VT is greater than
the strike price K. In order to calculate the price of the Option on a CPPI in
0 we have to discount the expected payoff of the option to 0. We have to check
at each rebalancing date wether Vt is above the floor or not. Furthermore, it
256 M. Escobar, A. Kiechle, L. Seco and R. Zagst

must hold VT > K. With ẑ we get

OoC d (0) = e−rT E (VT − K)+ |Wti > ẑ, i = 1, ..., N − 1


 

N 
!+
2 
(r− σ2 )∆t+σWti
Y
r∆t
= E[ FT − K + (V0 − F0 ) me − (m − 1)e
i=1
N
Y −1
−rT
·e 1{Wt >ẑ} ]. (30)
i
i=1

The price of the Option on a discrete CPPI can be obtained by using


Monte Carlo simulations in Equation 30. Greeks could also be computed by
MonteCarlo simulations as well within this setting.

6 Conclusion
In this paper we examined a dynamic asset allocation strategy and European
call options on this strategy. We first dealt with the CPPI strategy with contin-
uous rebalancing. We elaborated on Options on a CPPI finding a closed-form
solution for the option price as well as closed-form expressions for several use-
ful sensitivities like Delta, Gamma, Vega, Rho and Theta. In a second step,
discrete rebalancing was considered. In the discrete case an expectation ex-
pression was found for the price of the derivative depending on the path of the
underlying stock price. Therefore Monte Carlo simulations could be used to
calculate the price as well as the sensitivities. This work could be generalized
by studying other common derivatives on a CPPI, like Asian and American
options or more hand-made products targeting the two dimensional joint be-
haviour at maturity of the CPPI and the underlying stock price.

A Appendix
Proof. Proposition 3.1
Recall that if S follows a Geometric Brownian Motion under the risk-
neutral measure, St is given by
σ2
St = S0 e(r− 2
)t+σWt
.

Thus, in t we get for ST


σ2
)(T −t)+σWT −t
ST = St e(r− 2 . (31)
Option on a CPPI 257

The payoff of the Option on a CPPI is positive if VT > K. With Equation


(7) this becomes to

r
K − FT K − FT
VT > K ⇐⇒ αT STm + FT > K ⇐⇒ STm > ⇐⇒ ST > m
.
αT αT

Substituting ST from Equation (31) leads to

r r
K − FT σ2 K − FT
ST > m
⇐⇒ St e(r− 2 )(T −t)+σWT −t > m

αT αT
 r 
m K−FT
αT
 − (r − σ2
ln  St 2
)(T − t)
⇐⇒ WT −t > .
σ

Thus, we get a positive payoff for the Option on a CPPI at maturity T if

 
1 K−FT σ2
m
ln αT Stm
− (r − 2
)(T − t)
WT −t > =: z. (32)
σ

Now we can calculate the price of the Option on a CPPI in t. Therefore, we


have to discount the expected payoff in T to t.

OoC(t) = E e−r(T −t) (VT − K)+ |=t = e−r(T −t) E (VT − K)+ |=t
   

Z∞
−r(T −t)
= e (αT sm +
T + FT − K) f (sT )dsT
0
Z∞
= e−r(T −t) (αT sm
T + FT − K)f (sT )dsT
r
m K−FT
αT

Z∞
σ2
= e−r(T −t) (αT Stm em((r− 2 )(T −t)+σwT −t ) + FT − K)f (wT −t )dwT −t
z
258 M. Escobar, A. Kiechle, L. Seco and R. Zagst

Z∞
σ2
= e−r(T −t) αT Stm em((r− 2
)(T −t)+σwT −t )
f (wT −t )dwT −t
z

Z∞
−r(T −t)
+e (FT − K) f (wT −t )dwT −t
z

Z∞ w2
−r(T −t)
2
m((r− σ2 )(T −t)+σwT −t ) 1 −t
− 2(TT −t)
= e αT Stm e p e dwT −t
2π(T − t)
z
  
−r(T −t) z
+e (FT − K) 1 − N √
T −t
Z∞
−r(T −t) 1
= e αT Stm · p
2π(T − t)
z

σ2 m2 σ 2 (T −t)
)(T −t)− 2(T1−t) (wT
2 2 2 2
−t −2mσ(T −t)wT −t +m σ (T −t) )+
·em(r− 2 2 dwT −t
  
−r(T −t) z
+e (FT − K) 1 − N √
T −t
σ2 m2 σ 2 (T −t)
= e−r(T −t) αT Stm em(r− 2
)(T −t)+ 2

Z∞
1 1 2
· p e− 2(T −t) (wT −t −mσ(T −t)) dwT −t
2π(T − t)
z
  
−r(T −t) z
+e (FT − K) 1 − N √
T −t
  
−r(T −t)
2
m m(r− σ2 )(T −t)+
m2 σ 2 (T −t) z − mσ(T − t)
= e αT St e 2 1−N √
T −t
  
z
+e−r(T −t) (FT − K) 1 − N √
T −t
Ct (T −t)(r−m(r− σ2 )−m2 σ2 ) m m(r− σ2 )(T −t)+ m2 σ2 (T −t)
= e−r(T −t) e 2 2 S e
t
2 2
Stm
     
z − mσ(T − t) −r(T −t) z
1−N √ +e (FT − K) 1 − N √
T −t T −t
   
−z + mσ(T − t) z
= Ct N √ + e−r(T −t) (FT − K)N − √ (33)
T −t T −t
Option on a CPPI 259

By substituting Ct by Ct = Vt − Ft = αt Stm and z from Equation (32) we


get

 
αT Stm
 2

1
m
+ (r − σ2 )(T − t) + mσ 2 (T − t)
ln K−FT
OoC(t) = αt Stm N  √ 
σ T −t
 
αT Stm
 
1 σ2
m
ln K−FT
+ (r − 2
)(T − t)
+e−r(T −t) (FT − K) N  √ 
σ T −t

 
C0 σ2 2
With αt = S0m
· eβt and β = r − m(r − 2
) − m2 σ2 , we get for αT :

Ct β(T −t)
αT = ·e .
Stm

Now, we can make the following transformation:

 
Ct β(T −t) m
ln (αT Stm ) = ln Ct eβ(T −t) = ln Ct + β(T − t).

= ln e St
Stm

With this we define d1 (t) and d2 (t).

σ2
−ln(K − FT ) + ln Ct + β(T − t) + m(r − 2
)(T − t) + m2 σ 2 (T − t)
d1 (t) = √
mσ T − t
 
αt Stm 2 σ2
ln K−F T
+ (r + m 2
)(T − t)
= √
mσ T − t

and

d2 (t) = d1 (t) − mσ T − t .
260 M. Escobar, A. Kiechle, L. Seco and R. Zagst

2
ln m−1 + σ2 ∆t
Proof. Proposition 5.4 Let ẑ := m
σ
. Then,

E[VT |C1] = E [VT |Wti > z, i = 1, ..., N ]

N
!
2
(r− σ2 )∆t+σWti
Y
r∆t
= E[ FT + (V0 − F0 ) (me − (m − 1)e )
i=1
N
Y
· 1{Wt >ẑ} ]
i
i=1

Z∞ Z∞ N 
2 
!
(r− σ2 )∆t+σwti
Y
= ... FT + (V0 − F0 ) me − (m − 1)er∆t
ẑ ẑ i=1

f (w1 ) · · · f (wN ) dw1 · · · dwN

N Z ∞
Y
= FT f (wti )dwti + (V0 − F0 )
i=1 ẑ

N Z∞ 
σ2
Y 
· me(r− 2
)∆t+σwti
− (m − 1)er∆t f (wti )dwti
i=1 ẑ

N Z ∞
2
Y 1 wt
i
= FT √ e− 2∆t dwti + (V0 − F0 )
i=1 ẑ
2π∆t

N Z∞  wt2
Y σ2
 1 i
· me(r− 2
)∆t+σwti
− (m − 1)er∆t √ e− 2∆t dwti
i=1 ẑ
2π∆t
 N 

= FT 1 − N √ + (V0 − F0 )
∆t
N       
Y
r∆t ẑ − σ∆t r∆t ẑ
· me 1−N √ − (m − 1)e 1−N √
i=1
∆t ∆t
  N

= FT 1 − N √ + (V0 − F0 )
∆t
      N
rT ẑ − σ∆t ẑ
·e m 1−N √ − (m − 1) 1 − N √ .
∆t ∆t
Option on a CPPI 261

2
ln m−1 + σ2 ∆t
Substituting ẑ = m
σ
leads to the result.
2
!N
m
ln m−1 − σ ∆t
e−rT E[VT |C1] = F0 N √ 2 + (V0 − F0 )
σ ∆t
" 2
! 2
!#N
m
ln m−1 + σ2 ∆t m
ln m−1 − σ2 ∆t
· mN √ − (m − 1) N √
σ ∆t σ ∆t

References
[1] Acharya, V., Lasse H.P., Asset Pricing and Liquidity Risk, London Busi-
ness School Working paper (2003).

[2] Balder, S., Brandl, M., Mahayni, A., Effectiveness of CPPI Strategies
under Discrete Time Trading Working paper, (2005).

[3] Basak, S., A Comparative Study of Portfolio Insurance. The Journal of


Economic Dynamics and Control26 (2002), 63 - 86.

[4] Black Fischer, and Andre Perold, Theory of constant proportion portfolio
insurance, Journal of Economic Dynamics and Control 16 (1992) 403-426.

[5] Bertrand, P., Prigent, J.L., Portfolio Insurance Strategies: OBPI versus
CPPI, Document de Travail n02A13, GREQAM et Universit Montpellier
1 2002.

[6] Black, F., Jones, R., Simplifying Portfolio Insurance, The Journal of Port-
folio Management (1987) 48-51

[7] Boulier, J.F., Kanniganti, A., Expected Performance and Risks of various
Portfolio Insurance Strategies Direction Recherche et Innovation CCF,
1995.

[8] Escobar, M., Kiechle, A,. L. Seco, L., Zagst, R. Constant Leverage Strate-
gies103 (2009).

[9] Grossman, S., Villa, J., Portfolio Insurance in Complete Markets: A Note.
Journal of Business62 (1989), 473 - 476.

[10] Hull, J.C., Options, Futures and Other Derivatives Pearson Prentice Hall,
2005.
262 M. Escobar, A. Kiechle, L. Seco and R. Zagst

[11] Ineichen, A.M., Absolute Returns: The Risk and Opportunities of Hedge
Fund Investing, Wiley Finance, 2002.

[12] Kraus, J., CPPI versus Protective Put - ein theoretischer und praktischer
Vergleich, Bachelorarbeit Technische Universität München, 2005.

[13] Leland, H.E., Who should buy Portfolio Insurance, Journal of Finance35
(1980), 581 - 594.

[14] Perold, A., Sharpe, W., Dynamic Strategies for Asset Allocation, Finan-
cial Analyst Journal 01/02, (1988), 16-27.

[15] Zagst, R., Interest Rate Management, Springer Finance, 2002.

Received: August, 2010

You might also like