Option On A CPPI
Option On A CPPI
Option On A CPPI
5, 229 - 262
Option on a CPPI
Marcos Escobar
Andreas Kiechle
Luis Seco
Rudi Zagst
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.
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.
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}
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
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
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
Using this Lemma we can derive a closed-form expression for the portfolio
value Vt of a CPPI with continuous rebalancing.
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.
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 .
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 .
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 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
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
1 1 2
N’(x) = √ · e− 2 x .
2π
x 1 2
N”(x) = − √ · e− 2 x .
2π
240 M. Escobar, A. Kiechle, L. Seco and R. Zagst
∂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
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.
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.
N 0 (d1 ) (m − 1)
ΓOoC
S = √ + m(m − 1) αt Stm−2 · N(d1 ). (13)
σ T − t · St2
∂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
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.
∂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
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
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.
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.
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
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
(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
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).
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
Having done these calculations we can now give the price of a discrete CPPI.
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.
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
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.
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
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
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
.
r
K − FT K − FT
VT > K ⇐⇒ αT STm + FT > K ⇐⇒ STm > ⇐⇒ ST > m
.
αT αT
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
1 K−FT σ2
m
ln αT Stm
− (r − 2
)(T − t)
WT −t > =: z. (32)
σ
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
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
Ct β(T −t) m
ln (αT Stm ) = ln Ct eβ(T −t) = ln Ct + β(T − t).
= ln e St
Stm
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,
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
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
ẑ
= 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
ẑ
= 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
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