Constant Proportion Portfolio Insurance

CPPI tries to give an investor two things at once: upside from risky assets such as equities and downside protection from risk-free assets such as government bonds.

It works with three numbers:

• Floor — the value below which the portfolio should not fall. It is the present value of the capital to be protected.
• Cushion (gap) — portfolio value minus floor. This is the money you can afford to put at risk.
• Multiplier (m) — a fixed constant that sets how many times the cushion goes into risky assets. It defines leverage. In practice multipliers are 3 to 5.

The name comes from the constant rule linking the risky allocation to the floor.

The workbook's example. ₹100 must be protected at the end of a 3-year product. Its present value — the floor — is taken as a round ₹90. Cushion = ₹10. Multiplier = 5.

• Risky assets: 5 × (100 − 90) = ₹50
• Risk-free assets: 100 − 50 = ₹50

If the risky assets fall to ₹40, the portfolio is worth ₹50 + ₹40 = ₹90 — exactly the floor. Any further fall threatens the capital protection. So before setting the multiplier, the manager must work out how far the risky asset could fall in the worst case before there is time to rebalance. The higher the multiple, the higher the upside — and the higher the risk of breaching the floor.

The exposure to risky assets must be rebalanced as values change, which is why the workbook calls CPPI an actively managed rebalancing strategy.

Floor            = Protected amount ÷ (1 + r)^n
Cushion          = Portfolio value − Floor
Risky investment = m × Cushion
Risk-free        = Portfolio value − Risky investment

The workbook's Chapter 21 question. An investor gives a fund manager ₹200 lakh for 5 years and insists on no erosion of that capital. The risk-free rate is 8%; the firm limits the multiplier to 2.

Floor     = 200 ÷ (1.08)^5 = ₹136.11 lakh
Cushion   = 200 − 136.11   = ₹63.89 lakh
Risky     = 2 × 63.89      = ₹127.78 lakh
Risk-free = 200 − 127.78   = ₹72.22 lakh

Illustrative extension — why CPPI buys high and sells low. Holding the floor at ₹136.11 lakh and the risk-free leg unchanged for simplicity:

The rule adds to equities after they rise and cuts after they fall — the opposite of a constant mix strategy.

Another Chapter 21 question: portfolio ₹150 crore, floor ₹100 crore, multiplier 3 → risky exposure 3 × 50 = ₹150 crore, the whole portfolio.

Chapter 21 (Portfolio Rebalancing), section 21.6, defines CPPI, the floor, cushion and multiplier, and works the ₹100 / ₹90 / m = 5 example. Two Chapter 21 questions compute the risky exposure directly (₹150 crore; ₹127.78 lakh and ₹72.22 lakh). Expect those computations and a question on the practical range of the multiplier.

• The floor is a present value, not the protected amount itself. ₹200 lakh protected over 5 years at 8% gives a floor of ₹136.11 lakh.
• Multiply the cushion, not the portfolio value. m × (portfolio − floor).
• Multipliers in practice: 3 to 5.
• Higher m = more upside and more risk of breaching the floor. The workbook's example breaches at a risky-asset value of ₹40.
• CPPI is active rebalancing; buy and hold is passive. The workbook's sample question on "no limit on the upside" and a portfolio that becomes a function of risky assets is describing buy and hold, not CPPI.
• CPPI buys after rises and sells after falls; constant mix does the opposite.