An Empirical Analysis of CPPI Strategies for Credit Index Tranches

Abstract

To analyze the capacity of a constant proportion portfolio insurance (CPPI) strategy as a capital protection method for a portfolio of credit index tranches, this article investigates how the features of the strategy, along with the characteristics of credit risk exposures, affect the performance of a credit CPPI investment. The empirical results show that its performance depends on the aggressiveness of the leverage strategy employed. The larger the multiplier assigned to a CPPI strategy, the greater the net asset value of a CPPI portfolio, but also the higher the incidence of lower net asset values when the market performs badly. Moreover, risky investments on the tranche with a larger implied leverage offer a more variable risk–return profile than those on tranches with smaller degrees of leverages. The additional leverage that might be introduced into a credit portfolio through investments on CDO tranches differentiates a credit CPPI portfolio from CPPI portfolios of other asset classes. In general, the credit CPPI strategy performs poorly in highly volatile markets. When the value of risky investments falls sharply before the portfolio can be readjusted, the CPPI mechanism may even fail to provide principal protection.

TOPICS: Credit risk management, CLOs, CDOs, and other structured credit, portfolio construction, global markets